2025 Economic Outlook

Highlights:

• A strong but choosier consumer, coupled with a better-valued, more productive workforce has landed the economy in a good place.
• My baseline outlook is good. How economic policy uncertainty resolves will matter. But, with what we know today, I expect more upside than downside in terms of growth. I see more risk on the inflation side.
• The Fed remains well-positioned regardless of how the economy develops. Were employment to falter or inflation to re-emerge, we have the tools to respond.

Thank you for that kind introduction, and happy new year. I like economic outlook events. They challenge me to organize my thoughts on what's happened and what's to come. So, I'll test those perspectives with you today and look forward to your questions and advice. I should note that I speak only for myself and not for anyone else on the Federal Open Market Committee (FOMC) or in the Federal Reserve System.

A Good Year
I should start by calling out the strength of the overall data. Most estimates have 2024 GDP growth ending up in the range of 2.7 percent. The unemployment rate is at 4.2 percent, near most estimates of its natural rate. Twelve-month headline PCE inflation is down to 2.4 percent, near our 2 percent target.

I think it's fair to say: No one predicted this, and that includes me. That's an important reminder at an economic outlook event. If you think back, when the FOMC raised rates aggressively in 2022 and 2023, a recession was widely forecasted. Of course it was. Rates were at their highest level in 15 years, and the traditional recession indicators were flashing. The yield curve inverted and stayed that way for over two years. The Conference Board's Leading Economic Index declined for 2 1/2 years. Shocks like the failure of Silicon Valley Bank and the conflict in the Middle East looked ominous.

Yet here we are.

How did we get here? I'd, of course, love to give the FOMC full credit. But, while I do hope you think our actions and credibility have been of value, there have been multiple contributors. I'd like to mention four.

First is the strength of the consumer. The U.S. economy has returned to its prepandemic GDP trend, a feat we never achieved after the Great Recession, and one that I don't think any other advanced economy can claim. While fiscal spending and data center growth sparked by artificial intelligence (AI) have played a part, consumers have been the real story. Those with higher wealth have seen their asset valuations rise. Those with lower incomes have largely held onto their jobs and seen real wages grow. Consumer spending represents almost 70 percent of GDP and shows no signs of slowing.

Second is labor market resilience. Employers, scarred by the post-pandemic labor shortage and aware that the days of ample labor supply are likely over, tell me they don't want to get caught short workers again. As a result, while cautious employers are allowing headcount to drift downward through attrition and reduced hiring, they are slow to reduce staff. The layoff rate remains near historic lows. A low hiring, low firing labor market is still a healthy one.

Third is increased price sensitivity. Early improvement on inflation came from the supply side, as supply chains and labor supply recovered. But now we're also getting help on the demand side: Consumers, frustrated by high prices, are becoming more price conscious - trading down from beef to chicken, from sit-down restaurants to fast casual, from brand names to private labels. They're waiting for promotions or moving to lower-priced outlets. The saying is, "The cure for high prices is high prices," and that's what we're seeing. Price-setters are learning their ability to raise prices is now limited by consumer responses. Call that price elasticity in action.

Fourth is a surge in productivity. If we take a step back, all of this is pretty remarkable. How is inflation coming down amid strong growth? How are we growing so robustly even as job gains slow? The answer seems to be a strong 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. What's behind this surge? Everyone's thoughts tend to jump to AI, and perhaps that will be the case in time, but I believe the more likely story is our recent experience. Firms, unable to find workers two years ago, invested heavily in automation and more efficient processes and are now reaping the benefits. Also, more recently, as the labor market has normalized, turnover has slowed, and you know experienced workers get more done.

A strong but choosier consumer, coupled with a better-valued, more productive workforce has landed the economy in a good place. As a consequence, the FOMC has recalibrated the federal funds rate down 100 basis points to 4.3 percent. Inflation is not yet back to target, so we still have more work to do, but we don't think we need to be nearly as restrictive as we once were to finish that job.

That tells you a bit about where we are today, but I would venture to guess many of you want to hear about where we will be tomorrow.

Uncertainty Lingers
You might think that would be straightforward. After all, much of the uncertainty that dominated the news over the last year is now behind us. The Fed has finally cut rates and outlined the path forward. The election results are in. Taylor and Travis stayed together. Lower uncertainty usually creates supportive conditions for investment, hiring and growth.

To some extent, that's happening. In financial markets, uncertainty appears to have fallen significantly. Unlike a year ago, the market path for rates seems calibrated with the median of the FOMC forecast. At the long end of the curve, there seems to be increased understanding that rates are unlikely to come down as much as some might have hoped.

As a result, deal markets seem to be opening back up for developers and acquirers. Equity markets remain remarkably buoyant. Business surveys also show optimism up considerably. The most recent small business survey showed the biggest monthly sentiment jump in its 40-year history. There's a sense of relief to be past the election and to have clarity on the direction of travel, particularly for sectors confident they will benefit from anticipated changes.

But, even when you know the direction you're going, it's hard to book a trip without knowing your final destination. One of our Richmond Fed economists, Marina Azzimonti, has studied economic policy uncertainty around elections. She identifies uncertainty that persists beyond the election outcome, notably what agenda is actually implemented and how. That's where uncertainty still remains quite pronounced.

Take tariffs, for example. What tariff rates will actually be imposed? On what countries? On which products? For how long? Will there be retaliation? If so, at what levels? Through tariffs or through export restrictions on key commodities? How will supply chains evolve in response? How will manufacturers, retailers, and consumers react? I could lay out a comparable set of questions around other policy areas in the discussion, such as immigration, regulation, government spending and taxation.

Uncertainty should come down as policies are finalized, although it's easy to imagine an extended period of back and forth.

Speculating on 2025
Now, if I were you, I might be thinking, "Tom, this is an economic outlook conference, but you still haven't given me your economic outlook!" That's fair. So, what do I see?

My baseline outlook is positive. After all, as I said earlier, consumer spending is more than two-thirds of GDP, and so long as people keep their jobs and asset values remain solid, they should continue to spend. With business optimism so high and labor supply unlikely to continue to grow so robustly, it feels like the current labor market equilibrium is more likely to break toward hiring than toward firing, with, of course, some differences by sector. For example, in my district, there's particular concern about the path forward for the federal workforce. At the same time, consumer pressure on price-setters should continue to push inflation down. Overall, that would be a good outcome for the U.S. economy.

How economic policy uncertainty resolves will matter. But, with what we know today, I expect more upside than downside in terms of growth. That's why you see so much business optimism. If I'm wrong, the damage could be lessened by the potential to walk some of those policies back. I see more risk on the inflation side. Wage and product costs could see pressure. If they do, given recent experience with inflation, price-setters might have more courage to pass costs along.

But that's speculation; none of us know how all of this will play out. So, it's best to give it some time, and learn more about the path forward. And you can never ignore the impact on the economy from unanticipated events, as we've seen before from markets, international conflicts, and the pandemic. I expect the story for the coming year to be more about supply and demand - and perhaps geopolitics - than monetary policy. That said, the Fed remains well positioned regardless of how the economy develops. Were employment to falter or inflation to reemerge, we have the tools to respond. I hope that provides some comfort as we embark into the new year. Thank you.