Fed outlook 2025: Key insights for fixed income investors

• We believe the most likely path is for the Fed to bring rates down to around 4% in the first half of 2025, and then pause.
• Fed policy in 2025 will depend on economic data. Key metrics to watch include inflation and the labor market.
• Given the expected path of Fed policy, we see opportunities for investors in the very front end of the curve, managing interest rate risk with bond laddering and seeking higher income outside of core bonds.

At its final meeting of 2024, the Federal Reserve cut interest rates by 25 basis points; the Fed has now cut rates by 100 basis points since September 2024.¹

So, what may be in store for Fed policy in 2025? And how can investors use bond ETFs to position fixed income portfolios to potentially benefit from the Fed’s expected path? Read on to find out.

One of the best ways to get insight into how the U.S. central bank views the economy is the Summary of Economic Projections (SEP), which was first released in 2012. This data pack includes the so-called Dot Plot, which incorporates each Fed governor’s expectation for the fed funds rate over the next few years. The Dot Plot indicates the governors’ expectations for 50 basis points of rate cuts in 2025, which would bring the fed fund rate to a range of 3.75% to 4%.²

The SEP also includes long-term forecasts from Fed governors, which vary widely across the committee. The highest, or most “hawkish” estimates call for a longer run policy rate as high as 3.9%, while the lower, more “dovish” governors expect that rate to be around 2.4%. (See Figure 2)

Looking out into 2025, we believe the most likely path is for the Fed to bring rates down to around 4% in the coming meetings, and then pause, depending on how the inflation and employment data evolves.

Why is that our base case for 2025? As of November 2024, the U.S. Core Personal Consumption Expenditures (PCE) Price Index was up 2.8% on an annualized basis.³ While that’s down from a rate of 3.4% a year prior, it’s still above the Fed’s stated 2% target.

“We’ve made a great deal of progress” in lowering inflation toward the 2% target, but year-over-year inflation readings are “moving sideways,” Federal Reserve Chairman Jay Powell said in a press conference following the FOMC’s Dec. 18 meeting.⁴ Barring “further progress on bringing inflation down” it is “appropriate for [the Fed] to move more cautiously” with additional rate cuts.

The BlackRock Investment Institute, meanwhile, foresees “persistent inflation pressures fueled by rising geopolitical fragmentation, plus big spending on the AI buildout and the low-carbon transition.”⁵ (Read more in BII’s 2025 Investment Outlook)

Combined with America’s rising debt and deficits, that macroeconomic backdrop suggests long-term Treasury yields will likely remain ‘higher for longer’ as investors demand higher compensation for risk.

How far and fast the Fed will cut in 2025 — and if they move rates at all — will be dependent on economic data, barring exogenous shocks like the COVID-19 pandemic. Fed Chairman Powell has repeatedly stressed the Fed is “data dependent” in its decision-making, with a stated long-term inflation target of 2%.⁶

Our outlook for Fed policy is based on expectations for the U.S. economy to slow slightly but remain in expansion — combined with our understanding of the Fed’s dual mandate.

The Fed’s so-called dual mandate is to keep prices stable, meaning inflation is low and predictable, and foster “maximum” employment, meaning most workers can get a job if they want one.⁸ These goals may occasionally come in conflict with each other. If monetary policy is too restrictive in an effort to subdue inflation, it may curb economic growth and lead to job losses.

The Fed’s primary goal is to monitor economic data and fine tune interest rates using a combination of tools. The main tool is setting the fed funds rate, which is the rate that banks can borrow money overnight from the central bank. Since the Global Financial Crisis, the Fed has also increased its use of its balance sheet — the ability to hold U.S. Treasury, agency debt and mortgage-backed securities (MBS) — as a means of governing the supply and demand for longer-term interest rates, which generally fall outside the scope of its fed funds rate.

By buying bonds, the Fed aims to lower long-term interest rates, making borrowing cheaper and stimulating economic activity. Conversely, reducing its holdings through bonds sales or letting bonds mature can exert upward pressure on interest rates, tightening monetary conditions.

The balance sheet was increased through bond purchases during the COVID-19 pandemic. In May 2022, the FOMC announced that it would begin reducing the size of the balance sheet. In May 2024, the committee announced that it was slowing the pace of the reduction from $60 billion to $25 billion for U.S. Treasuries and maintain the MBS reduction at $35 billion per month. The Fed is accomplishing this by letting bonds mature and not selling into the market. From May 2022 to November 2024, the Fed’s balance sheet declined by $2.0 trillion, from $8.9 trillion to $6.9 trillion.

Regardless of the path of Fed policy in 2025, here are some ways investors can use bond ETFs to position their portfolios:

• Put cash to work: If overnight interest rates stay higher for longer, investors could consider allocating to ultrashort duration or floating rate exposures via SGOV or FLOT.
• Build bond ladders: Bond ladders hold an equal weight to each calendar year and can allow investors to lock in income before interest rates fall.
• Seek higher income: Potentially boost fixed income returns with higher yielding bonds, such as high yield, emerging markets, bank loans and CLOs (USHY, EMB, BINC or CLOA).

In sum, investors can use bond ETFs to manage their portfolios regardless of the rate environment. Here is a summary of five interest rate scenarios and potential strategies for managing bond portfolios with iShares bond ETFs:

Using iShares to navigate changing interest rate environments