The Big Idea
Out-of-consensus calls on the economy in 2025
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My US economic forecast for next year is quite close to the consensus. I expect a slowdown to a still-solid pace of real GDP growth, continued moderation in the labor market and further disinflation, though at a pace that may disappoint Fed officials and financial markets. Still, there are key elements of the outlook that may play out differently than most analysts and investors expect. In particular, productivity may not relieve inflation pressures and the Fed may cut more and run QT longer than markets currently expect.
- No productivity revolution yet
Economists and Fed officials have begun to talk more about faster productivity growth as an explanation for the apparent contradiction between consistently above-trend real GDP growth and the downward path of inflation. For example, just this month, Minneapolis Fed President Kashkari cited faster productivity as a possible reason that the Fed may not cut rates “quite as far.” Richmond Fed President Barkin on November 12 said: “How are we growing so robustly even as job gains have slowed? The answer seems to be a healthy step up in productivity. In the 2010s, productivity grew at a 1.2 percent annualized rate; in 2023 and 2024, it has grown at 2.3 percent.” St. Louis Fed President Musalem and Chair Powell also both referenced faster productivity growth in their last speeches.
Financial market participants and many private economists have pointed to AI as a driver of more rapid efficiency gains. However, even those Fed policymakers that have mentioned better productivity have acknowledged that it is far too soon to realistically expect AI to affect the macroeconomic data. It is worth noting that in the 1990s, it was years before the advent and proliferation of the Internet ultimately led to a surge in the official productivity figures. AI may or may not lead to a similar acceleration in efficiency gains, but if it does, we are likely years away from seeing the impact in the aggregate data.
Circling back to Richmond Fed President Barkin’s framing of the productivity trends, I believe that such an optimistic take amounts to cherry picking the numbers. It is true that nonfarm business productivity grew at a robust 2.7% pace last year. However, the 2023 jump in efficiency gains followed a 1.3% drop in productivity in 2022, as job growth far outpaced the expansion in real GDP. In fact, 2022 was the worst year for nonfarm business productivity in decades.
Given the massive short-term volatility in the productivity figures, the best approach is to look at multi-year averages. In this case, the natural timeframe would be to look at nonfarm business productivity growth since the start of pandemic in 2020. That average, over nearly five years, is 1.9% per year. By comparison, the average over the prior two decades was 1.8%. So, productivity growth may accelerate going forward, but in my view likely has not done so yet.
The main significance of whether efficiency gains have accelerated relates to how inflation-prone the economy is. If productivity growth has picked up, then the economy can expand faster without generating inflation pressures. Economists would then say that the economy’s potential growth rate has risen. While this is about as close as economics comes to offering a free lunch, I am skeptical that the Fed can count on accelerating productivity to solve its remaining inflation problem.
There is broad agreement that after an extended period of restrictive monetary policy to tamp down inflation, the Fed is in a position to continue cutting rates in 2025. However, perhaps in part due to optimism that the incoming Trump administration’s policies will boost growth and inflation, financial markets have come to believe that the Fed will not be in a position to lower rates by much next year. By mid-November, fed funds and SOFR futures were pricing an end-2025 funds rate of 3.85% to 3.90%.
I rarely find myself taking a dovish monetary policy view, but at the moment, I believe that the financial markets have overshot. I continue to believe that a neutral policy rate is likely in the 3.0% to 3.5% range, and I am currently projecting that the funds rate will end 2025 in the upper half of that range. This call puts me in line with the September FOMC dot projections and with the consensus of private-sector economists, but it is noticeably lower than current market pricing.
I would note that I too am optimistic about the potential positive growth implications of the shift in government policy, which appears to be a key driver of the swing in financial market expectations. In my view, marginal tax rate cuts and a business-friendlier regulatory approach could exert a noticeable boost to growth without necessarily sparking inflation, though I would add that sharp tariff increases could offset much of that lift. In any case, the most important point in my view is that it will be well into 2025 before the new administration is able to implement major policy changes, which means that the bulk of the economic impact is likely to come in 2026 and beyond, not next year.
Heading toward the end of 2024, the consensus among economists and strategists is that the Fed is poised to end its balance sheet reduction within the next few months. Most projections that I have seen have the FOMC ending QT either around the end of 2024 or in the first quarter of 2025.
However, in my view, the Fed’s balance sheet remains significantly larger than is necessary to satisfy the financial system’s liquidity needs. As of mid-November, bank reserves plus reverse RP take up was still over $3.4 trillion, which is several hundred billion dollars larger than I believe is the level that the Fed should be aiming for.
The New York Fed markets desk and others within the Federal Reserve system have identified a handful of metrics within the money market universe that would provide early warning signals that financing conditions are tightening. So far, these measures have barely moved, indicating that liquidity remains well above required levels. On November 12, Roberto Perli, the Manager of the Fed’s System Open Market Account, noted that the quarter-end volatility on September 30 was not an indication that “reserve supply is anything other than abundant.”
In any case, I expect that the Fed’s balance sheet reduction will continue through most or all of 2025. I look for the current pace of Treasury redemptions of $25 billion a month to continue through March, followed by a gradual tapering to zero, with QT finally ending at the turn of the year.
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