Investors are underestimating how deep rate cuts will be in 2025, Goldman says

• The market is underestimating how much the Federal Reserve's will cut rates in 2025, Goldman Sachs says.
• The Fed fund rate will drop to 3.25-3.50% by the end of 2025, the bank estimates.

Markets are underestimating how much the Federal Reserve is going to cut interest rates next year, Goldman Sachs predicted.

In the bank's latest macro outlook, it estimated that the Fed funds rate could drop to 3.25%-3.5% in 2025.

That's considerably below what investors see as the highest-probability outcome, as calculated by the CME FedWatch Tool. It currently sees a 30% chance of rates being in the 3.75%-4.0% range by the end of next year.

The disconnect reflects the degree to which investors are wary about the potentially inflationary effect President-elect Donald Trump's policies could have. The Fed generally tackles inflation by raising interest rates, which is seen challenging the central bank's plan for further easing.

But Goldman forecasts that Trump's tariffs might actually justify rate cuts by prompting an economic slowdown in the early going. In these situations, the Fed eases monetary policy to revive activity.

"If anything, the threat of a near-term growth drag from tariffs and the Fed leadership's continued preference for frontloaded policy normalization have strengthened our confidence in sequential cuts through early next year," Goldman analysts led by chief economist Jan Hatzius wrote on Thursday.

As for reinflation concerns, Goldman assumes that Trump's tariffs will only target China and auto exports coming from Europe and Mexico. In this scenario, US core inflation would reach a "benign" level of 2.4% by late 2025.

However, if the incoming president follows through on a pledge to implement across-the-board 10% tariffs on all US trade, that figure would rise to 3.1% by early 2026.

Still, Goldman noted that disinflation has been ongoing globally, and is a trend that is likely to keep up.

"Against this backdrop, we do not expect the US election outcome to derail the policy normalization process that is currently underway, and see most major central banks easing significantly further through 2025," the note said.

To be sure, Goldman acknowledged that Trump's policies remain uncertain, creating the risk of an earlier stopping point for the Fed's cutting cycle. Much of this will depend on the Fed's willingness to respond preemptively to future inflation boosts.

But for now, growth risks are the Fed's key priority, Goldman noted.