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The global fight against inflation is entering a new phase. Central banks in developed countries began cutting interest rates in earnest this summer after price pressures fell sharply last year. However, it has proven difficult to persistently return inflation to the 2% target. As the end of the year approaches, the threat of new inflation looms and the future path of interest rates becomes more uncertain.
The US Federal Reserve (Fed) cut interest rates by 25 basis points (bps) on Wednesday, but gave traders a shot at seeing the reality of their expectations. Investors had expected interest rates and inflation to continue normalizing next year. However, the committee’s “dot plot” of interest rate forecasts for 2025 showed a smaller rate cut than the forecast made before the US presidential election. The inflation outlook was also raised slightly. The news ended the S&P 500’s relentless rally this year.
The “last mile” of inflation is a particular worry for the Fed. Annual core personal consumption expenditure, the country’s preferred measure of inflation, has been gradually rising after falling to 2.6% in June. However, the rise itself is not much to worry about. This has been driven by economic resilience and high housing-related inflation, which has tended to lag behind other factors and is now easing. The policy interest rate also remains at a relatively restrictive level of 4.25% to 4.5%. The bigger concern is what new price pressures will emerge in the future.
Donald Trump’s election victory changes the Fed’s calculations. Key elements of his agenda, including tariffs, tax cuts, and immigration cuts for America’s trading partners, will create inflationary pressures. The president-elect’s weaponization of uncertainty, especially on trade, makes it difficult to know how and to what extent he will implement his plans. The looming risk of a government shutdown in recent days didn’t help either. Federal Reserve Chairman Jay Powell acknowledged that committee members are beginning to factor in President Trump’s influence in their forecasts.
The next president’s agenda will also affect the outlook for other central banks. In the UK, the Bank of England said on Thursday trade uncertainty had increased “significantly” after the central bank kept interest rates on hold. However, the UK’s near-term inflation trajectory is further complicated by domestic factors. Annual price growth has returned to 2.6% after falling below 2% in September. The autumn budget, which includes tax increases and minimum wage hikes, will further increase costs for businesses. That said, weak business activity may offset some of the pricing pressures. Poor quality labor market data also clouds interest rate setting.
The European Central Bank is bucking this trend. Christine Lagarde, the euro zone’s governor, was in a celebratory mood this week when she declared that the eurozone’s “darkest days” of high inflation were over. The ECB cut interest rates by 25 bps this month and has signaled further cuts in the new year. In fact, inflation is under control, hovering around 2%.
The euro zone’s challenge is a widespread economic downturn, which will worsen if President Trump follows through on his promise to raise tariffs. On Friday, the president-elect threatened via social media to tax the bloc if it fails to buy large quantities of U.S. oil and gas. Political instability in France and Germany is having an impact on tax and spending plans, and the fate of fiscal policy is also uncertain.
Although the rise in interest rates has been largely smooth and coordinated, the rate-cutting cycle has been punctuated by periods of stagnation and is becoming characterized by divergence. Central bankers will receive some credit for averting the worst of the global inflation shock in 2021-2022. But now the problem is closer to home, and the uncertain and diverse economic consequences of Trump 2.0 are weighing even more heavily on their minds. The job of Mr. Powell and other central bankers will not get any easier in 2025.
