The topic of inflation is a common theme in recent years not just in financial media but across mainstream as well, while also making headlines are decisions by central banks like the US Federal Reserve (Fed) to cool down runaway inflation such as its decision on January 29th to keep its target rate where it's already at.
According to Investing.com's news update on the Fed decision, it was driven by factors like inflation that "remains somewhat elevated."
In this article, I take a closer look at what some expectations are for inflation in 2025, potential future Fed decisions around interest rates, and which sectors could be most impacted by those decisions, as well as why this is relevant to a future-minded investor growing a diversified portfolio.
The Backdrop: A Continuing Cycle of Inflation and Interest Rate Movements
A common metric tracked when talking about inflation is changes in the consumer price index (CPI), and as you can see in the chart below from the US Bureau of Labor Statistics, which tracks the 12-month % change in the CPI from Dec 2004 to Dec 2024, there has been a continuous cycle of ups and downs in this inflation metric over the last two decades:
For instance, as we can see in the above chart, around the time of the 2008/2009 global financial crisis there was an extended period of recession (grey area) coupled with a rapid drop in the inflation rate (red line), which in fact appeared to have been a severely deflationary period. Years later, around the 2020 global Covid pandemic we see another grey line indicating a recession, along with a drop in inflation, however the post-pandemic economic recovery that followed also saw a drastic rise in the inflation rate to nearly 10%.
The chart below shows how the Fed responded to the Covid recession in 2020, by literally reducing the federal funds effective rate to nearly 0%, as their "target rate" which is used by commercial banks to borrow /lend to each other overnight, and which could influence other interest rates too and the cost of debt. As inflation grew rapidly in 2022, we can see how the fed funds rate was greatly increased to over 5%, and it was only in the fall of 2024 that the Fed began cutting it, indicated by the dip in the chart.
While a 5% interest rate may seem excessive, for those that are familiar with history I want to point out the following chart which shows the fed funds rate between the 1960s through 2024, showing that actually it was a period in the late 1970s that saw the rate approaching a whopping 20%. So, in comparison, the fed rate hikes in 2022 to just over 5% may not seem that high after all, within the larger context of history. The difference now also is that this most recent round of rate hikes in 2022 was not followed by a recession yet, yet the US saw a significant recession in the early 1980s (grey areas on chart) after the late-70s rate hikes.
As we are wrapping up the first month of January 2025 now and the first Fed decision of the year, we also know from history that both interest rate hikes and inflation levels seem to go through their cycles, as do recessions, and therefore I think we can expect more such cycles in the future, and so the question I had as a future-minded analyst is what kind of future upside factors and future downside risks we can expect from such cycles, and which market sectors and stocks may see a tailwind from the current environment and which could see headwinds.
The Milton Friedman View: Oversupply of Money and Excess Government Spending
In the 1970s, Nobel laureate economist Milton Friedman spoke at the University of San Diego, which is available on Youtube, and pointed to the causes of inflation as oversupply of money along with excess government spending, both of which are not the result of business or consumer decisions but decisions by politicians and central banks, since politicians control federal budgets and central banks like the Fed have tools to influence the money supply.
Of course, certain types of increased government spending, like on the military and national security, can provide a tailwind to certain market sectors such as defense stocks. Some that come to mind right away are major federal contractors such as Northrop Grumman (NYSE:NOC), Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), and Booz Allen (NYSE:BAH) Hamilton, among others, who sell a variety of products and services to the federal government.
As the current government in Washington, and majority in Congress, is considered pro-defense, these are some stocks to keep an eye on for future upside, however also consider that there is a major federal cost-cutting /efficiency drive underway via the new Department of Government Efficiency so it is too early to tell whether defense spending will also see major cuts.
Sector Tailwind: Banks and Insurance
When thinking about what sectors could benefit most from a continuation of an elevated interest rate environment, based on my research of over 200 companies over the last few years, two sectors are notable to mention and they are banking and insurance.
Though many larger banks today are diversified beyond just making loans, such as ones that also have fee-driven services like asset management or wealth advisory, I think the core business of many banks still remains lending and as such an environment with elevated interest rates could continue to drive higher interest revenue for banks. At the same time, it could also result in higher funding costs since banks might fund themselves from a combination of customer deposits and borrowing from other banks or from the Fed.
Some bank stocks that come to mind who have very large lending or credit card businesses, which depend on interest revenue growth, are Capital One (NYSE:COF), Ally Financial (NYSE:ALLY), and PNC Financial (NYSE:PNC), to name some.
Large insurance companies, although they do not make interest from lending like banks do, they often hold a large portfolio of fixed-income securities such as bonds and earn interest revenue from them, in addition to their core business of earning insurance premiums on policies sold. So, an insurance company with a large portfolio of fixed-income assets on its books may benefit from an extended period of higher interest rates if it boosts interest revenue on its fixed income portfolio. Unlike banks who have to often pay interest on customer deposits, insurance companies do not have customer deposit accounts since they are not a bank.
Some insurance companies in that category that I would highlight are Prudential Financial (NYSE:PRU), Metlife (NYSE:MET), and Manulife Financial (NYSE:MFC).
Sector Headwind: REITs
Although many sectors may be negatively impacted by a higher interest rate environment, and the resulting higher cost of borrowing, particularly companies that have high capital expenditures financed through debt, one sector that I personally think could see a continued headwind from higher costs of borrowing will be real estate.
Specifically for investors of publicly-traded companies, I would highlight REIT stocks as a sector that could see higher costs of borrowing or refinancing when interest rates are higher, and the higher interest expense can impact earnings on the income statement.
So, when picking REITs recently I was bullish on ones that already have a positive and stable credit rating from major rating agencies, and a modest or low debt/equity ratio vs similar peers. One such stock would be CareTrust REIT (NYSE:CTRE), which invests in a portfolio of skilled nursing and assisted-living facilities throughout the US.
A future-minded investor could take the long-term view, for example, and grab a quality REIT stock while it is undervalued, with the expectation that a future low interest rate environment could provide significant upside to this sector and its share prices too.
Future Fed Decisions: What CME Fedwatch is Saying
In the run up to the Jan. 29th Fed decision which came out at 2 p.m. EST, rate probability tracker CME Fedwatch showed a 99% probability that the Fed will keep its target rate the same.
Looking beyond January, what CME Fedwatch is pointing to, as of Wednesday afternoon, is at least a 71% probability that the current target rate will continue to be kept the same even after the March 19th meeting, which is a few months away. If this indeed turns out to be the case, then we can expect a continued elevated interest rate environment for a large part of 2025, but perhaps not at the levels of a year ago.
. 
Conclusion: 2025 Will Be a Mixed Bag
With the much-awaited January Fed decision now behind us, and rates staying where they are for now, we can take a moment for now at least to breath again, but what I can conclude is that 2025 will present a mixed bag for investors. This is why portfolio diversification is more important now than ever, in my general market opinion, since various market sectors could win or lose in various interest rate environments which are continually subject to change and cycles.
In addition, with the popularity of money-market mutual funds gaining traction in high interest rate environments, with some funds I researched seeing yields above 4%, I expect this portfolio segment.. money market funds.. to continue to see inflows during this type of environment as investors try to park cash in assets with higher yields.