Economic Developments - January 2025

Resilient Economic Activity and Sticky Inflation Point to Interest Rates Staying Higher for Longer

While a mix of "hot" and "cool" economic reports have driven some of the recent interest rate volatility, the overall picture shows that economic growth remained resilient over 2024, and that deceleration in inflation stalled in the latter half of the year. After slowing for much of 2024, December's labor report showed payroll growth jumping to 256,000 (up from a past six-month average of 142,000) and a decline in the unemployment rate to 4.1 percent, suggesting that the labor market may have firmed to end 2024. Meanwhile, measures of holiday shopping spending and personal consumption remain solid. Annual inflation as measured by the core Consumer Price Index (CPI) averaged around 3.3 percent over the second half of 2024 (though dipped to 3.2 percent in December), and the core Producer Price Index (PPI) has stabilized at a higher-than-pre-pandemic level, as measured on an annual basis.

The totality of indicators in recent months suggests that neither aggregate demand in the economy nor inflation pressures eased by as much as was previously expected. This implies that the current monetary policy stance is not restricting economic activity as much as previously thought, and, possibly, that the “neutral” short-term interest rate, where monetary policy is neither supporting nor restricting growth, is higher than the bond market and the Fed had anticipated.

As a result, fed funds futures markets have increased the expectation for the year-end 2026 fed funds rate from around 2.9 percent this past September to 3.9 percent as of this writing — a reduction in the expected amount of total rate easing. The Fed has also indicated an upward shift in its views on the trajectory of future short-term rates in its Q4 Summary of Economic Projections (SEP). In September, the median participant expected the federal funds rate to be 2.9 percent by the end of 2026, while the December SEP had that figure at 3.4 percent. Given that long-term rates are a function of expected short-term rates over time, the 10-year Treasury yield has risen.

Importantly, the rise in longer-term rates in recent months is not attributable to a meaningful increase in inflation expectations over the long term. The 10-year breakeven inflation rate (TIPS spread), which is derived from the difference between the 10-year Treasury bond at constant maturity and the yield on a 10-year Treasury Inflation-Protected Security (TIPS) bond, shows that inflation expectations have been relatively stable in recent months. The rise in longer-term rates, therefore, has been due almost entirely to an increase in the real component.

This indicates that bond markets still expect the Fed’s 2-percent inflation target to be achieved, and on a similar timeframe as before. However, the expected path for the fed funds rate going forward, required to achieve that goal, is now higher than previously expected after observing economic activity not slowing by as much as previously expected.

We are still expecting GDP growth to moderate in 2025 relative to 2024 but have only modestly revised our GDP forecast this month given incoming data and the recent rise in rates corresponding with apparent higher growth resiliency. Primarily, we modestly upgraded consumer spending over our forecast horizon. Largely offsetting this is a related wider trade deficit projection, and a modest downward revision to our expectation for housing investment, which is particularly interest rate-sensitive. Top-line inflation numbers in this forecast are modestly higher due to a higher expected energy price path, though the core inflation outlook was only minimally revised.

Lower Home Sales Will Continue, but Region Matters

With a higher expected outlook for mortgage rates, both the lock-in effect and affordability constraints are expected to be more persistent than predicted in our December forecast. As such, we have revised downward our projection for total home sales for 2025 and 2026 to 4.89 million and 5.25 million, respectively. The prior represents the continuation of a sales pace close to the 30-year low. This downward revision, however, is comparatively modest due to our view that a large share of transactions is currently being executed by less interest rate-sensitive parties, such as cash buyers or those driven by major life events. Conceptually, given the current economic environment, we think there is an approximate floor on the pace of existing home sales of around 4 million annualized units. As is typical, high-frequency mortgage application data has been volatile following the election and the holiday season, but, overall, it appears activity bounced back somewhat in Q4 relative to the trough in sales of 3.83 million in September.

In December, according to Realtor.com, active inventories of homes for sale were up 31 percent from the start of 2024, though remain historically tight (16 percent below December 2019 levels). This provides some ability for modest sales growth over the course of the year despite higher interest rates. However, the rise in inventories has not been driven by a proportionally faster pace of new listings over this past year, but rather by an increase in the time it takes to sell a home. We interpret this to mean that in some regions, the pool of potential buyers on the sidelines has shrunk and there is not sufficient purchase demand from first-time buyers, in particular, at current prices and mortgage rates. According to the National Association of REALTORS®, the first-time homebuyer share of purchases in 2024 fell to 24 percent, from 32 percent in 2023, the lowest level since data collection began in 1981.

One implication is that despite affordability measures and the lock-in effect currently being similar now to where they were at the start of 2024, home price appreciation is likely to decelerate. This month, we updated our quarterly home price forecast, making only modest revisions. As measured by the Fannie Mae Home Price Index (FNM-HPI), we project home price growth to decelerate this year to 3.5 percent from 5.8 percent in 2024 and to slow further to 1.7 percent in 2026. This rate of home price growth will likely be a slower pace than the rate of household income growth, which would contribute to the slow process of restoring affordability to levels that prevailed before the COVID pandemic.

However, the pace of moderation in home price appreciation and rise in for-sale inventories varies by region. As we have discussed previously, most of the regions with growing inventories of homes for sale are in the Sun Belt and other metros that have seen considerable new homebuilding in recent years. Most regions in the Northeast and Midwest have experienced little improvement in the number of homes available for sale, in part due to a lower infusion of new homes into the housing stock.

Going forward, we suspect the regions with higher inventories at the start of the year will disproportionately drive increases in home sales, to the extent that sales on a national level increase. However, these regions will also likely disproportionately contribute to the deceleration in home price appreciation. In contrast, tight-inventory regions will likely experience comparatively firmer home price appreciation but also see less improvement in sales transactions this year, as the lock-in effect and more limited new homebuilding continues to suppress the total inventory of homes for sale.

Regarding new home construction, many of the publicly traded homebuilders have reported large declines in their operating margins as larger incentives have been required to move sales this past half year. While there is a limit to how much homebuilders are willing to offer buydowns and other concessions, the large builders continue to provide forward guidance that emphasizes a commitment to hitting sales and delivery targets, and a willingness to use deeper concessions to do so. Similarly, the most recent reading of the National Association of Home Builders Market Sentiment Survey, which is weighted towards smaller homebuilders, saw an increase of three points to the index for expected sales over the next six months, hitting the highest level since April 2022.

Therefore, we continue to expect comparatively robust new single-family home sales and construction and have only modestly downgraded both measures in this month’s forecast considering higher mortgage rates. We do, however, expect comparative softening in starts relative to sales, as homebuilders now have a growing inventory of homes for sale already started and completed, and we expect builders to prioritize clearing this inventory before ramping up new construction.