Inflation and Interest Rates Will Bedevil Many Bankers in 2025

Rates and inflation are intertwined. And both experts and consumers are beginning to see more signals of rising inflation.

By Steve Cocheo, Senior Executive Editor at The Financial Brand

Published on January 21st, 2025 in Product Strategies

Economically, the only thing that bankers can be certain of right now is ongoing uncertainty.

The outlook for inflation is hazy at best, in spite of periodic bouts of market euphoria, and multiple factors may erode the optimism many bankers have bought into. The uncertainty on interest rates, inextricably tied up in inflation expectations, is even hazier. Where not long ago the debate was on how fast the Federal Reserve would cut short-term rates, now there is speculation that before yearend the Fed will be pushing rates back up again.

The handiest readout of rates is the yield curve, which many institutions have been struggling with for some time.

"For the last quarter or so there has been extremely cautious optimism among bankers because the curve is positively sloped and that helps," says Keith Reagan, executive director at Darling Consulting Group. "Over the last couple of years bankers have been hoping that the curve would just get to flat, because flat was better than inverted." (The traditional, typical curve shows shorter-term rates being lower than longer-term rates, with the curve rising as time progresses.)

"We’ve been up, we’ve been down, and we’ve been volatile," says Reagan, "but things have not been consistent." In spite of a dose of optimism, he continues, some institutions are still effectively sitting on the sidelines before really committing themselves to an outlook on rates.

"On the way up, the market continuously underestimated the pace at which the Fed was going to increase rates," says Adam Stockton, managing director, Curinos. "Similarly, on the way down the market has for the most part been too optimistic in terms of anticipating Fed decreases."

A generation of bankers who came up in historically low and long low-rate times saw the run-up in inflation and interest rates but considered it an aberration.

"Despite what they might have said publicly, many privately thought, ‘Yeah, rates are going to come back really low again’," says Joshua Siegel, chairman and CEO at StoneCastle Partners, LLC. "Now they’ve started realizing that maybe rates aren’t going to come that low, and that we may be where we are now for an extended period of time, if not permanently."

Going forward, he adds, bankers have to make sure that they tailor their strategic view to current facts. "People are always fighting the last war," says Siegel.

But the period of inflation from the pandemic to date, with the addition of higher rates, has a legacy that many banks will carry forward.

Reagan says one of the major lessons is how quickly rates can move and how that can impact deposits. "Rate-sensitive customers are real and they moved their money around quite a bit," says Reagan. "For the previous 15 years deposit rates were effectively at 0% and depositors were on autopilot. They’re not on autopilot anymore and probably won’t be for some time."

One recent development among those depositors is the return of people who disintermediated their bank deposits to buy U.S. Treasury securities directly, when those rates pulled ahead of bank deposits. For many, tapping the government’s Treasury Direct website made this much easier.

Reagan says a number of his consulting clients have reported that as those customers’ Treasury securities mature, some have come back to their banks. For some, there’s a preference for an insured deposit. But for others realization came that owning a T-bill isn’t the same as having a CD, when you want to get out early.

"If rates have moved against you, there’s a real market prepayment penalty if you go to sell it," says Reagan. "It’s usually a lot more of a penalty than most banks’ CDs carry for early withdrawal."

Read more: Why Banks Should Anticipate a Return of the ‘Roaring ’20s’

Inflation and the Federal Reserve’s Ongoing Battle

In mid-January, financial markets reacted enthusiastically to the Labor Department’s December 2024 inflation report. The overall consumer-price index hit 2.9%, an increase of 0.4% over November, and the third consecutive rise in the monthly overall inflation rate. (The rate was 9.1% in June 2022, a 40-year high.) What excited the markets wasn’t the overall rate, but the core consumer-price index, which rose by only 0.2%, the smallest gain since last July, and slightly below what experts had projected. The core measure excludes food and energy expenses.

Minutes from the Fed Open Market Committee meeting of mid-December — when the Fed funds rate was reduced by a quarter point — indicate that the view of most members was that a case could be made for higher-than-anticipated inflation levels in 2025. (The Fed’s target for the overall inflation rate is 2%.) The minutes, and other signals, have many expecting that in its late January policy meeting the committee will vote to hold rates steady.

In an interview with the Wall Street Journal, Beth Hammack, president of the Federal Reserve Bank of Cleveland and a relatively new voting member of the Fed policy group, discussed her dissent from the decision to make the quarter-point trim.

"We still have an inflation problem. We still have a rate-of-change problem that we need to address," Hammack told the Journal. "We’ve made amazing progress on it, but we need to continue to finish the job." She said she felt the committee could have been patient and held off on the cut.

Hammack — formerly treasurer at Goldman Sachs — added that many years from now financial history will look back on the low rates of the 2010s as an exception.

In a mid-January speech New York Federal Reserve Bank President John Williams said, "Looking ahead, I expect inflation to gradually decline toward our 2% goal in the coming years." [Emphasis added.]

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Is Inflation Optimism Justified — Or Is Worse Coming?

The exclusion of food and energy prices from the core inflation measure carries some irony, in that for many Americans, those are two of the first places they feel economic pain. For many, the price of a dozen eggs or a tank of gasoline are more relevant measures of inflation, right at hand versus a remote government figure. The median view of consumers taking part in the New York Fed’s Survey of Consumer Expectations is that the inflation rate will be 3% over 2025, 3% for 2025-2027, and 2.6% for 2025-2030.

While the Fed has been waging an ongoing fight to rein in inflation, Siegel, a veteran markets watcher, says there’s more pressure for continuing inflation than for inflation lessening significantly.

He sees five main reasons for this likelihood:

• As rates continue to be higher than in the recent past, this continues higher costs to service the national debt.

• In turn, because many federal services must be provided, more debt has be issued, which creates more inflation.

• Lowering domestic taxes will reduce a key source of federal income and that will feed back into the first two reasons.

• Tariffs — new ones or increased charges — raise the cost of goods for purchasers, both companies and consumers. This creates additional inflation. President Trump indicated in late November that he intended to hike tariffs on China as well as on Canada and Mexico. (Since the inauguration the hammer of tariffs has come up multiple times in presidential remarks.)

• Deportations, in his view, will create wage inflation as Americans taking the place of immigrant workers will insist on higher pay levels.

An analysis by JPMorgan Private Bank says that "tariffs are likely to lead to higher inflation without corresponding economic growth."

"To me, there’s way more risk of minor to major inflation, and very little risk of rates coming down. I can’t come up with an economic case for rates falling significantly," says Siegel. "Short rates are controlled by the government, but long rates are controlled by the markets. There’s far more pressure on rates going up than coming down."

The question, Siegel continues, is whether banks have included this possibility in their rate-setting plans and their asset-liability management practices.

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Where Are Banks’ Mindsets?

Bankers are beginning to hear a greater variety of viewpoints on the direction of interest rates than had been the case when the Fed began its rate cutting, according to Stockton of Curinos.

"Economists are willing to come out with positions that differ from the consensus," says Stockton. "Some have said they expect continued cuts, just starting a little later, going a little slower. But there are others who have positions that there will be no more rate cuts — and even a couple who have said that rate hikes might be more likely than rate cuts."

Stockton says this dispersion of viewpoints would have been appropriate a couple of years ago, as well, in recognition that there has been uncertainty about what to expect for some time.

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"It’s not to say that any of these economists are necessarily reading the data wrong — we could still go in different directions," says Stockton. "Job reports continue to fluctuate, some areas of inflation remain stubbornly high, and there’s a lot of global macroeconomic uncertainty because of armed conflicts and the potential for different political outcomes."

The experts interviewed generally feel banks need to plan based on multiple scenarios, rather than picking one and focusing exclusively on that possibility.

"There’s a conventional wisdom that a falling rate environment is pretty easy to handle, from a bank perspective, and that’s not always the case," Stockton explains. "We’ve seen some banks that have cut deposit rates too far and have lost really valuable deposits. Reacquiring them is a lot more expensive than not cutting rates quite so much."

Bankers often think in terms of rates rising or rates falling, but Keith Reagan thinks it is important for them to have a strategy in place for the rate curve staying as it is now for some time. Having a view on all three scenarios, with variations, is critical now.

Reagan believes today’s situation demands devotion to basic ALCO blocking and tackling, pricing carefully.

"When there’s this much volatility, I’m okay hitting singles," says Reagan, tapping into a second sport for illustration. "This is a hard time to swing for the fences."

Siegel thinks bankers have to stop managing by rear-view mirror. They need to look ahead and make judgments based on where things may be headed, not where they’ve been — and specifically for their own situations. It’s critical to have a realistic view of where rates are going because banks ought to be maintaining a consistent spread as rates rise and as they fall — and to understand the customer base on both sides of the balance sheet. It’s Banking 101 to Siegel.

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Rate Uncertainty May Drive Decisions Beyond ALCO

However, under today’s circumstances handling volatile rates is taking a toll — it’s becoming the final straw. Siegel thinks 2025 will be an above-average year for mergers and acquisitions among smaller banks.

"It isn’t that banks are being crushed out of business," says Siegel. "It’s just too tiring and too hard to make yet another effort to define the bank differently from the next one, especially if it’s an old management team and an old shareholder base."

Those who don’t go this way have to realize that they can’t continue to lean into rate management, and need to work harder on controlling noninterest expense. He believes much of this is going to require using artificial intelligence for mid-office functions, not to fire employees but to redeploy them to higher-value tasks. A key function that AI lends itself to is fraud prevention. Siegel says the technology can do the heavy lifting and human "managers" of the AI processes can add the finesse. Assembling credit files, a rote task, can be done by AI, freeing up human bankers to higher-level credit functions.

"Institutions that learn how to utilize this technology wisely and carefully can cut their operating costs. Humans can do the things that actually move the needle," says Siegel, "which includes reducing loan default risk and increasing new deposits and loans coming in the door."

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About the Author

Profile PhotoSteve Cocheo is the Senior Executive Editor at The Financial Brand, with over 40 years in financial journalism, including the ABA Banking Journal and Banking Exchange.

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