Economic Developments - February 2025

Economy, Labor Market, and Inflation Start 2025 on Firm Footing

Incoming economic data since our last forecast continue to show that the economy entered 2025 on firm footing. GDP rose at a 2.3 percent annualized rate in the fourth quarter, close to our forecast of 2.4 percent. While we had predicted consumption would continue to grow at a robust annualized pace of 3.3 percent, the actual 4.2 percent growth rate surprised to the upside and implies a stronger-than-expected handoff to the first quarter, causing an upward revision to our near-term consumption forecast, though we do continue to expect deceleration moving forward. Due to inventory investment being a large drag on Q4 GDP growth, final sales to private domestic purchasers, which is sometimes considered “core GDP” and more indicative of underlying trends, posted an even stronger 3.2 percent annualized growth rate compared to topline GDP growth of 2.3 percent.

Additionally, the January labor report, which incorporated the annual benchmarking process in the establishment survey and updated population estimates in the household survey, showed that the labor market has firmed in recent months. While the benchmarking exercise revised downward the total nonfarm employment level by 589,000 through March 2024, this was less than the preliminary estimate of 818,000. Updates to seasonal adjustments and the model that estimates the pace of firm creation/closures showed payroll employment gains only averaging 82,000 from last June through August. However, net hiring in November and December was revised upward and the three-month moving average of employment gains in January hit 237,000 in post-revision data, the highest level since March 2023. This paints a picture of a reaccelerating labor market to end 2024.

In the household survey, adjustments to the population series to reflect the Census Bureau’s estimates of higher immigration in recent years caused an upward revision of more than 2 million employed people in January (historical household survey data is not revised). The unemployment rate declined to 4.0 percent; an eight-month low. The two employment surveys, when adjusting for definitional differences, now show a significantly smaller gap in estimated total employment levels, a source of downside risk in previous outlooks. With more consistent data on employment levels in the two surveys, we are now more confident that labor market conditions remain sturdy.

A continuation of strong economic growth and a firming in the labor market is consistent with increased inflation pressures relative to earlier in 2024. In January, the core CPI rose 0.4 percent over the month and ticked up one-tenth to 3.3 percent compared to a year ago. While some of the hotter-than-expected CPI may be due to ongoing seasonal adjustment issues that have pushed inflation readings upward in the first quarter of recent years, year-over-year core CPI readings have not decelerated meaningfully in eight months. Further, core CPI has risen at a 3.8 percent annualized rate over the past three months and 3.7 percent over the past six months. As a result of incoming data, we now expect headline and core CPI to grow at 2.8 and 2.9 percent on a Q4/Q4 basis in 2025, upward revisions of three-tenths and four-tenths, respectively.

Financial markets are now pricing in just one 25-basis-point rate cut this year, in line with our updated view of only one fed funds rate cut occurring in 2025, which we now expect will occur in September (we previously anticipated two cuts).

Tariffs and Trade Policy Uncertainty Adds to Risk Around the Forecast

While all economic forecasts are subject to risks, current trade policy uncertainty presents higher-than-usual risks to our forecast this month. For this forecast, we have incorporated the additional 10 percent tariff on imports from China, but we have not included any of the other tariffs measures currently being discussed. Implementing the increase in the tariff rate on imports from China leads to a slight downward revision to our growth forecast for 2025 of about one-tenth and an upward revision to our core inflation forecast for the next year of roughly the same magnitude. While the effects are notable, they are modest compared to other factors influencing revisions to our forecast, highlighted by the muted response from financial markets. In contrast, financial markets have responded more strongly to news about potential tariffs on Canada and Mexico, which currently present downside risk to our baseline forecast.

Sustained uncertainty may weigh on business investment and consumer spending as firms and households delay activities. For instance, the Economic Policy Uncertainty Index recently spiked to the highest levels on record outside of recessionary periods.

Trade Policy and Effects on Mortgage Rates Unclear 

It’s not clear how all of this will affect mortgage rates. If additional tariffs are implemented, there are plausible scenarios where it could lead to either higher or lower mortgage rates, depending on the details, timing, and the reaction of foreign nations and central banks.

The direct impact of levying a tariff on imports is to make such goods comparatively more expensive to buyers, reducing overall purchases and the trade deficit. However, the opposite side of the international accounting ledger is that the trade deficit has a reciprocal amount of foreign investment flow into the U.S. economy. These funds, among other things, are used to fund Treasury issuance. Therefore, a reduction in the trade deficit, all else equal, should put upward pressure on longer-term interest rates.

However, other nations would likely implement retaliatory tariffs, and currency exchange rates would adjust. On net, we expect increasing tariffs is more likely to reduce overall trade volumes (imports and exports) than to reduce the trade deficit. Looking back at the 2018-2019 period when tariffs were previously increased, the trade deficit as a share of GDP was not meaningfully changed. Interest rates may still move upward if the near-term increase in price levels leads to a rise in inflationary expectations, and the Fed responds by holding rates higher for longer.

Alternatively, if escalating tariffs sufficiently slow economic growth, then expectations for further Fed easing may rise, and combined with flight-to-safety dynamics, long-run interest rates could decline. While it is difficult to isolate these effects in the 2018-2019 period given housing construction pulling back and the Fed reversing its rate-hiking cycle, longer-term interest rates, including mortgage rates, did ultimately fall in 2019 following the escalation of tariffs.

Further complicating this analysis is how tariffs fit into broader fiscal policy. If tariff revenues are used to reduce fiscal deficits, then they would translate into a contractionary fiscal policy, suggesting a lower fed funds rate will be needed going forward to maintain the dual employment and 2-percent inflation target. However, if proceeds are used to finance additional spending or offset other tax cuts, then the effects on aggregate demand in the economy and monetary policy response would differ.

In summary, we are holding to one of our major themes for the year. While we expect mortgage rates to remain comparatively elevated as a baseline, periods of heightened volatility should be expected. Rates are likely to move, perhaps sharply, as trade, fiscal, and monetary policy developments unfold and associated economic data is released.

Home Sales Expected to Remain Sluggish – Only Modest Revisions to the Outlook

Exiting homes sales increased 2.2 percent in December to a seasonally adjusted pace of 4.24 million, modestly stronger than we had anticipated. Furthermore, though volatile around the holiday season, purchase mortgage applications have remained, on average, higher than anticipated. We have upwardly revised our near-term sales outlook, reflecting this stronger incoming data. Still, we believe sales are likely to remain subdued, in light of continued lock-in effects and affordability challenges.

Pending home sales, which, on average, lead closings by 30-45 days, fell 5.5 percent in December, pointing to some pull-back in sales in Q1 from the December pace. We project 2025 existing home sales to rise slightly from 2024 by 2.9 percent, but this would reflect a pace still down 22 percent from 2019.

We have made only modest revisions to our new home sales and single-family housing starts outlooks, primarily driven by recent incoming data. Housing starts rose somewhat more than we had anticipated in December, while new home sales, following disruptions from hurricanes in October, rebounded by somewhat less than anticipated.

Fundamentally, our view remains intact that new home sales and construction will remain comparatively strong this year, as homebuilders have shown a willingness to continue to use concessions to drive sales, though a build-up of inventories in some key metros presents some downside risk to this forecast. We expect the pace of single-family starts to fall slightly by 1.4 percent in 2025 after rising 6.5 percent in 2024, as builders work off some of their existing inventory of completed homes for sale. It should be noted, however, that beyond previously mentioned mortgage rate risk, the future development of tariff policies also presents risk to the pace of new home construction due to effects on the prices of lumber and other building materials.