Inflation and Interest Rates: How Employers Should Prepare for 2025

As much attention as the labor shortage received in recent years, inflation has loomed even larger in the minds of policymakers, business leaders, and the public. This intense focus began in 2021, when the Consumer Price Index (CPI) began rising abruptly in response to numerous factors, including historic supply chain pressures. This spike peaked in June 2022 and—although inflation has fallen steadily and is now below its historical average—concerns about rising prices have persisted.

One reason for this sustained focus is that the Federal Reserve Board remained committed to constraining inflation by raising interest rates and maintaining them at a level not seen since the early 2000s. Although necessary, this policy generated tension in markets and the business community.

In September 2024, due to falling inflation and a rapidly cooling labor market, the Fed implemented a 50 basis-point (0.5 percentage point) cut to its target interest rate. There is widespread belief that more cuts are coming in the months ahead. As such, inflation characteristics and the Fed’s aggressiveness in lowering rates will likely be a dominant issue in 2025.
 

The Policy Response to Rising Inflation

One function of the Fed is to promote price stability through monetary policy. When inflation climbs, the standard response is to raise interest rates, which increases borrowing costs and puts downward pressure on inflation via reduced demand.

The Fed examines several metrics when making monetary policy decisions, though a widely discussed measure is its 2% year-over-year inflation target. Rather than the more commonly known CPI, however, this benchmark refers to year-over-year growth in the Personal Consumption Expenditures Index (PCE).

As shown in Figure 1, both the CPI and the PCE saw a sharp spike in 2021. The year-over-year PCE index rose from less than 2% in February 2021 to over 6% by the end of that year. After peaking at 7.1% in June 2022, the PCE index has fallen steadily over the past two years and has been below 3% since October 2023. Although this index provided some mixed signals about inflation in the early part of 2024, it has consistently fallen in recent months and stood at just 2.2% in August 2024.

A primary reason for falling inflation over the past two years has been the Fed’s willingness to curb price increases via interest rate hikes. From early 2022 to the middle of 2023, the Fed increased the target federal funds rate (FFR) from 0.25% to 5.5%.

Taking such an aggressive approach to lowering inflation always entails some risk because raising interest rates tends to suppress consumer spending, investment, and economic growth. However, the U.S. economy was remarkably resilient throughout this period, which allowed the Fed to maintain a 5.5% target on the FFR for over a year leading up to its 0.5 percentage point cut in September 2024. Assuming that inflation remains at or below its current level, there is widespread belief this initial cut is one of several that will occur in future months as the Fed attempts to achieve the often-discussed economic “soft landing” (i.e., curbing a period of high inflation without triggering a recession).

3 Potential Paths in 2025 & Takeaways for Employers

Developments in recent months strongly suggest inflation is trending down to the Fed’s 2% target. Evidence of labor market cooling has further eased inflation concerns, so much so that the Fed cut its target rate by 0.5 percentage points in September and appears to be pursuing a steady series of cuts going forward.

As certain as these future developments may seem, it is important to note that key economic indicators offered some mixed signals in 2024, and global economic conditions remain volatile. Such uncertainty makes it difficult to provide a definitive forecast for inflation and interest rates in 2025, but here are three possible scenarios and their relative likelihood.
 

Scenario 1 (Most Likely): Stabilization in Inflation and Declining Interest Rates

The latest PCE year-over-year inflation value (2.2% in August 2024) aligns with the Fed’s target, which significantly eases concerns about inflation. Furthermore, the rapidly cooling labor market will likely lead to more aggressive rate cuts than previously expected. In fact, the most recent Federal Open Market Committee (FOMC) projections suggest that the Fed’s target rate could fall another 0.5 percentage points by the end of 2024 and an additional percentage point in 2025. (Expectations of individual FOMC participants vary significantly.)

Absent an unforeseen shock that fundamentally changes economic conditions, available evidence strongly suggests that the Fed will pursue a series of steady interest rates cuts through 2025, with inflation remaining at or near its current level.

Key Takeaways for Employers:

• High borrowing costs have created challenges for many employers in recent years. Organizations in this position will welcome falling interest rates because this will facilitate lower borrowing costs and make key investments more affordable.
• Lower borrowing costs may also encourage firms to take measured risks aimed at innovation and future growth (e.g., investing in areas that make aspects of doing business cheaper, such as new technologies, employee training programs, acquiring capital assets, and expanding the business).
• Lower interest rates also tend to boost consumer spending, with an especially strong impact on products that are frequently purchased via financing. Thus, industries whose customers rely heavily on borrowing should benefit significantly from interest rate cuts.
• Any continued decline in inflation would likely stem, in part, from cooling wage growth. Although the labor market remains tight by historical standards, falling wage inflation would make it easier for firms to attract and retain talent.
   

Scenario 2 (Unlikely, but Possible): A Modest Rise in Inflation

One key feature of the U.S. economy in the first half of 2024 was uncertainty and mixed signals. For example, several monthly jobs reports came in well above or below expectations, and data on compensation growth was similarly mixed.

Although signals in the latter half of 2024 have clearly pointed toward falling inflation and a cooling labor market, a modest reversal of this trend is possible. For example, overly aggressive interest rate cuts could prompt a return to overheated labor market conditions, which could put upward pressure on wages and overall inflation. Such a scenario is unlikely. However, in such a case, the Fed’s response would almost certainly be to scale back or even halt interest rate cuts.

Key Takeaways for Employers:

• In this scenario, borrowing costs would remain somewhat elevated, which would deter business investment relative to optimal conditions. Firms that rely heavily on borrowing to facilitate operations would be worse off relative to Scenario 1. Similarly, firms would be less willing to finance risky investments (e.g., in innovative tech).
• We would also expect consumer spending to be suppressed compared to Scenario 1. This would be especially true for products purchased via financing (e.g., housing, cars, etc.).
• Assuming that this rise in inflation was paired with a return to overheated labor market conditions, organizations would again face intense competition in the labor market and strong growth in compensation costs. Attracting and retaining talent would be more difficult and costly in this environment, compared with Scenario 1.
   

Scenario 3 (Very Unlikely): High Inflation Returns

The 2021-2022 inflation spike was spurred by extremely unusual economic conditions, including shocks caused by the worst pandemic in 100 years. Thus, there is no reason to expect that—having exited this period of pandemic and high inflation—we would return to those conditions in 2025. However, one key lesson from the recent past is that massive economic shocks can arise with no warning. And several current issues around the world (e.g., geopolitical conflicts) could metastasize and spike inflation again.

Key Takeaways for Employers:

• A resurgence of inflation would put policymakers in a difficult position, especially if the shock also decreased aggregate demand and suppressed economic growth (an outcome referred to as “stagflation”). If that happened, the Fed would likely raise interest rates and borrowing costs would rise. Most firms would respond by cutting back on debt-funded investments. Companies that rely heavily on borrowing to fund operations would be hit especially hard.
• Consumer spending would stagnate or fall, especially for products that are frequently purchased via financing.
• It is unclear what labor market conditions would look like in this scenario because they would depend on the nature of the economic shock.

Overall outlook: The labor market remains relatively tight by historical standards, but conditions have loosened rapidly in recent months. As such, on average, employers should expect comparatively favorable labor market conditions in 2025, especially those organizations that are willing to pursue innovative ways to find, train, and retain workers.

Similarly, the data strongly indicate that inflation has returned to normal, which should hail the return of lower interest rates and correspondingly good conditions for consumer spending, investment, and innovation. In short, after years of uncertainty and upheaval, 2025 seems poised to provide a refreshing blend of normalcy and opportunity.