Almost a year ago, at the press conference following the December 2023 Federal Open Market Committee (FOMC) meeting, there was a sea-change in rate expectations on the back of chair Jerome Powell’s dovish comments. So much so, that by the start of 2024 the market was factoring in six rate cuts in the US during this year. Rate cut expectations for the UK and euro area followed, too.
Yet as the first half of the year unfolded, rate expectations were scaled back. Then, as we entered the second half of the year, the expectation of large rate cuts came back onto the agenda. However, as we have progressed through this period, these too have been scaled back but not quite to the extent as previously. After all, the US Federal Reserve, Bank of England and European Central Bank have all delivered policy easing.
The Fed cut rates by 0.5% in September and by a further 0.25% in November, to a target range of 4.5% to 4.75%. In the statement to accompany that November cut, the FOMC noted the solid pace of activity. They said that while labour conditions had eased, unemployment had risen but remained low, while in the accompanying minutes they noted that, “labour market conditions remained solid”.
The Fed saw inflation trending towards their 2% objective, and judged the risks as balanced between achieving their inflation and employment objectives. The Fed is also shrinking its balance sheet in a steady and predictable way. Market pricing points to the funds rate declining gradually, to around 4% over the next year and then reaching a floor of 3.7%. The market sees the floor for rates at 3.7% in the UK and 1.5% in the euro area.
As I have stated before, I think US interest rates will ease further, but it is still unclear how low they will go. Aggressive easing seems unlikely, given the economy’s current modest growth trajectory and in view of the stimulative fiscal policy. The scale of the budget deficit is not yet worrying the market, as it is seen as constructive for growth, but there is uncertainty about how tariffs will play out. They are seen as adding to price pressures and dampening global growth but should not prevent the Fed from easing further, although gradual cuts seem most likely.
There is always a degree of uncertainty with any new administration, but the announcement of President Trump’s new economic team has reinforced existing market expectations that policy will be geared to tech, boosting innovation and tax cuts to boost demand. Yet concerns persist about the scale of the deficit (although the new Treasury Secretary has said he will reduce it) and the uncertain impact of tariffs.
This depends upon how high and extensive they are, and on how firms and other countries respond. The higher and more widespread tariff increases are, the greater the fallout. Tariffs would force higher relative prices in the US on the goods impacted, and incentivise targeted firms or countries to react. The hope is countries do not respond with beggar-my-neighbour policies, as trade wars dent trade and global growth.
President Trump's decision last week to target Canada and Mexico – as well as China – demonstrates his willingness to use tariffs as a "catch-all" for non-economic issues. The US policy to use tariffs more aggressively is an escalation of a recent trend. Globally, in recent years, there has been a shift towards interventionist policies, with subsidies, regulatory barriers and tariffs. Increasingly, a national security lens or addressing the climate crisis has reinforced this.
In the euro area, meanwhile, it is seen as far more likely that interest rates will fall significantly. The ECB has already cut three times recently, and a further reduction is expected in December, given the recent weakness of euro area data – the manufacturing purchasing managers’ index in November was a weak 45.2. Admittedly, this index has been below the 50 threshold since mid-2022. Inflation was 2.3% in November with core inflation at 2.7%, but is expected to trend towards the 2% target, allowing the ECB to ease further.
Importantly, there are indications (following comments from the ECB’s chief economist Philip Lane) that the ECB will move away from its current approach of setting rates based on the latest data to a more forward-looking approach. This is long overdue. It is remarkable how rate decisions at both the ECB and BOE are coincident – with a meeting-by-meeting data-driven approach based on latest economic figures – rather than forward-looking, taking into account the expected future economic outlook.
Rates look set to fall significantly further in the euro area compared with the US or UK, and this may weigh on the euro. Alongside poor economic data, political problems hang over Germany, with an election in the new year. And now France is facing a budgetary and political crisis. The problem is very different in scale to the problems impacting Greece – that triggered contagion and a euro area crisis over a decade ago – but nonetheless it is indicative of deep-rooted problems in France, with weak growth, high debt, and a need to keep the markets and international investors on-side.
The UK should, perhaps, take note.
The fallout from the Budget continues to weigh on confidence in the UK, although in surveys it is noticeable that firms are more optimistic about their own position than the wider economy. This may be a positive underlying factor but the economy lacks momentum and the second half of the year looks weak. It is not out of the question to talk about a possible recession if confidence continues to fall, hitting consumption and investment. For now, modest growth appears more likely, as real incomes grow.
The BOE voted 8-1 to cut rates by 0.25% to 4.75% in November. At that time consumer price inflation was 1.7% and is now 2.3%. In its statement the BOE said, “Based on the evolving evidence, a gradual approach to removing policy restraint remains appropriate.” That seems right, with gradual easing likely, and with rates down to 4% in our view by the autumn of next year.
There is little doubt the Fed, ECB and BOE have a bias to ease, but it is still unclear where central banks in the US, euro area or UK see neutral policy rates. This is likely to be driven by the wider policy debate, as well as heavily influenced by the latest economic data.
Please note, the value of your investments can go down as well as up.
