By Brian Johnson, Director of Investment Services

As we close out 2025, we always like to reflect on how certain economic and geopolitical events shaped the capital markets over the past 12 months. 2025 provided another reminder that the economy and fixed income markets rarely “follow the script.” Over the past year, we saw moderating inflation, albeit persistently above the Fed’s target, increased tariff implementation, a cooling labor market, and the longest government shutdown in U.S. history.

At the beginning of the year, the federal funds futures market reflected an implied probability of two, 25 basis point (0.25%) rate cuts in 2025. At the conclusion of the Federal Reserve’s Federal Open Market Committee (FOMC) meeting on December 10^th, the target range for the benchmark fed funds rate stood at 3.50 – 3.75%, following the third, 25 basis point cut of the year.

The vote among FOMC members on December 10^th showed the Committee’s varied opinions on the current target rate and where interest rate policy might be heading. For the first time since September of 2019, there were three dissents among the twelve voting members of the FOMC. Fed Governor Stephen Miran favored a larger, 50 basis point cut, while regional bank presidents Jeffrey Schmid of Kansas City and Austan Goolsbee of Chicago voted in favor of holding the target range steady at 3.75 – 4.00%.

As a reminder, the FOMC’s dual mandate focuses their attention on maximum employment and price stability. Fed officials are currently waiting on a backlog of employment and inflation data that was delayed due to the government shutdown. Despite that, there have been signs of slowing in the U.S. labor market. U.S. jobless claim applications climbed by 44,000 during the week of December 6^th, ending the week at 236,000. That number mildly outpaced the average of analyst expectations of 213,000.

With respect to the other side of the Fed’s dual mandate, inflation in the U.S. remains sticky – certainly with respect to the Fed’s policy target of 2.0%. September’s Consumer Price Index (CPI) report showed headline inflation rising 0.3%, representing an annualized increase of 3.0%. Core inflation for September (excluding food and energy) was also up for the month, rising 0.2%. The FOMC’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, also increased 0.3% in September, representing a 2.8% increase year-over-year.

As noted earlier, the FOMC is waiting on several delayed reports on inflation and employment from the U.S. Bureau of Labor Statistics that should be received the week of December 15^th. Some key details are expected to be missing from those reports, however. The government shutdown caused the Bureau of Labor Statistics to cancel the October CPI report, and it’s unclear what components of the October report will be available when the report for November is published. It is also expected that the report will not include October’s unemployment rate, resulting in the first ever gap in that data set.

The FOMC has been steadfast in its data dependent stance with respect to monetary policy decisions. Even with some gaps in the upcoming reports, a clearer picture on employment and inflation will be critical in determining their anticipated path forward in the new year. According to the FOMC’s newest “dot plot” projections (released at the conclusion of each policy meeting), it appears that most officials anticipate at least one more 25 basis point cut to the fed funds rate in 2026. In his press conference following the December meeting, FOMC Chair Jerome Powell indicated that further rate adjustments could be fewer in the new year stating, “We are well positioned to wait and see how the economy evolves.” The release of the employment and inflation data for November and December will be a key barometer in establishing policy in 2026.

Lowering the target range for the fed funds rate wasn’t the only key decision the Federal Reserve made at their meeting in December. They also announced Fed purchases of short-dated government bonds to help manage market liquidity levels. The anticipation is that the Fed will purchase around $40 billion of Treasury bills per month during their initial round. The goal of the purchases will be to give the Fed ample reserves to support open market operations aimed at managing the effective federal funds rate.

Looking ahead to 2026, there are several key factors that we believe will play an outsized role in the path of interest rates moving forward. The health of the U.S. labor market has become a key area of focus for the FOMC, while also trying to tackle inflation that’s persistently trending above their 2% target.

Against that backdrop, we believe there is a strong probability for the continued steepening of the yield curve through a trend of lower overnight and short-term rates with intermediate and long-term rates remaining stable with a bias towards the upside. Targeting a long-term investment strategy is a great way to build cash flow stability for your entity’s operating needs in today’s marketplace and for years to come. Even though it might seem counterintuitive to buy a lower yielding security than what you can receive in a liquid, overnight rate, stability in cash flows and predictable income can pay dividends over budget cycles when it comes to your investment strategy.  Remember that short-term yields can be one of the most volatile parts of the interest rate spectrum.

If you’re interested in discussing your current, or even different portfolio strategies, please contact your Ehlers Investment Adviser to learn more.

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