Lessons learned from the economy in 2024

Stephen Stanley | December 20, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The year now coming to an end was a tumultuous one for the US economy, with a roller coaster ride of strong and weak data over the course of the year.  In the end, economic growth was better than expected (yet again), but, unlike 2023, core inflation was also higher than projected going into the year.  There are many takeaways from this year.  But several bear on how the US economy may evolve in 2025 and beyond, namely, the challenges of forecasting, the volatility of inflation and the swings in Fed policy expectations.

Everything is in play

One of the mysteries of 2024 has been how the economy has yet again exceeded expectations by a wide margin and yet the labor market has cooled substantially and inflation has continued to moderate.  To set the stage, the FOMC in December 2023 projected that real GDP would grow by 1.4% in the upcoming year, while the unemployment rate would inch up to 4.1% and PCE inflation would slow to 2.4%.

The latest FOMC projections for 2024 were 2.5% for real GDP, nearly double the estimate from a year ago, but the other two key variables were barely changed from last December at 4.2% for the unemployment rate and 2.4% for headline inflation—to be fair, core inflation looks set to run 40 bp higher than the FOMC’s December 2023 forecast.

Economists have struggled to explain how the economy has been able to sustain such robust growth at the same time that the labor market is clearly softening and inflation continues to trend lower.  No clear consensus has developed yet, but the short answer is that everything is in play.

Economic models generally have to make fixed assumptions about certain fundamental building blocks to generate plausible forecasts.  The usual benchmarks that are assumed include the trend rate of potential real GDP growth, the long-run equilibrium unemployment rate, and the neutral policy rate that neither stimulates nor restrains the economy.  However, at the moment, all of these bedrock assumptions are up in the air.

An obvious answer to the robust growth mystery would be that the trend rate of potential real GDP advances has accelerated.  This is in turn would require either a rise in the pace of labor supply gains or in the underlying trend of productivity.  Both of these key metrics have been more volatile than usual in recent years.  Labor supply did see a massive pickup in 2022 and 2023, as immigration surged, but the influx of people slowed sharply in 2024 and seems poised to be curtailed further going forward.

Economists have consequently focused mainly on productivity growth.  It is true that productivity gains have been relatively high over the past 18 months, but this stretch follows the worst annual performance in decades in 2022, so it is far from a guarantee that efficiency gains have persistently accelerated.  Still, economists enter 2025 with questions about how fast the economy can expand without overheating.

Similarly, the FOMC is struggling with questions regarding the level of a neutral policy rate.  For years before and after pandemic, officials pegged the longer-run policy setting around 2.5%.  However, this was an unusually low estimate by broader historical standards. With 2% target inflation, such a nominal rate implies that real rates in the economy should be barely above zero.  As the quarters pass, the behavior of the economy increasingly suggests that the Fed’s policy stance is not as restrictive as generally thought. Otherwise, growth should have slowed dramatically by now.

As we move into 2025, this question of what setting of Fed policy neither boosts nor restricts the economy will be central to the monetary policy outlook.  The hawkish dot projections released this month reflect in part uncertainty over how much further the FOMC needs to cut rates to arrive at this elusive neutral stance.

With many of the foundations of economic modeling more up in the air than usual, the array of plausible outcomes for growth, the labor market, and inflation are noticeably wider than normal.  Forecasting will not be as straightforward as saying that if growth is stronger than expected, then the labor market and inflation will necessarily do this.  Rather, we could see surprising combinations, as was the case in 2024.

The underlying details sometimes matter more than the top line

Fed officials have struggled to get their hands around the inflation picture.  The core inflation data have been quite lumpy over the past 18 months.  In the final six months of 2023, the core PCE deflator increased at a 1.9% annualized pace.  Entering 2024, Fed officials and financial market participants were ready to declare victory and at one point early this year, fed funds futures were pricing rate cuts as soon as March.

Then, core inflation jumped in the first four months of this year, surging at a 4.1% annualized pace.  Just when it looked darkest, however, price pressures appeared to ease again.  In the four months from May through August, the core PCE deflator returned to a 1.9% annualized pace, ultimately contributing to the FOMC’s decision to slash rates by 50 basis points in September.  As soon as the Fed aggressively shifted its policy stance, core inflation picked up again, rising by 0.3% in September and in October.

Financial market participants and even Fed officials found themselves being jerked back and forth by these swings in the core inflation figures.  However, it did not have to be that way.  Much of the volatility in the aggregate core inflation figures described above was driven by the noisiest line items, most notably used vehicle prices and airfares.  Stripping out the most volatile categories from the core CPI, the swings laid out above still occurred but were much less extreme.

Entering 2025, one of the key questions that financial market participants and Fed officials alike will be asking is whether inflation on an underlying basis is still making reasonable progress toward 2%.  The experience of the past couple of years has shown that getting the correct answer to that question requires looking in the proper place and not being driven back and forth by high-frequency noise.

This lesson applies far more widely across the economic data universe.  For example, monthly payroll readings and weekly initial jobless claims figures often gyrate.  Digging into the details rather than reacting in a kneejerk fashion to a newswire headline often provides a far better answer—a shameless plug for the value of market economists!

Wild swings in fed expectations

This year also was a roller coaster for monetary policy expectations. Expectations for the fed funds rate 12 months out began 2024 at around 4%—this is where investors thought a year ago that the funds rate would be now—surged to almost 5% in the spring, when the inflation numbers accelerated, rallied to below 3% in September and then completed the round trip late in the year returning to 4% (Exhibit 1).

Exhibit 1: 12-Month-Ahead Fed Funds Futures

Source: Chicago Board of Trade, Bloomberg.

This is a timely reminder, because financial market participants are now settling into a narrative that the Fed is likely to move very little for years.  As of this writing, fed funds futures are pricing about 35 bp of rate cuts for all of 2025, just over one quarter-point move.  Looking further out, SOFR futures have that rate, which typically trades within a few basis points of the funds rate, within plus or minus 10 basis points of 4% in every quarter from September 2025 through March 2029.

I cannot tell you with certainty where the funds rate is going to be in 2029, but I am highly confident that the Fed is not going to be sitting still for nearly four years.  Presumably, the degree of volatility in policy expectations will decline in 2025 versus last year’s crazy ride, but it probably makes sense to keep your seat belt on and be prepared for turbulence.