Two days, two central banks, two different tones

The economist view – Melanie Baker, Senior Economist

US/Euro area: two days, two central banks, two different tones

Both the US Federal Reserve (the Fed) and the euro area’s European Central Bank (ECB) had monetary policy decisions this week. Both acted in line with consensus; the Fed stayed on hold and the ECB cut by 25bps. Both central banks continue to watch the data and are not pre-committing to any policy path. My impression was that both central banks see themselves cutting rates again this year too, but the tone from the ECB was more confident on that front. The ECB has not transitioned to a Fed-style ‘not in a hurry…we need to tread cautiously’ message, despite both central banks creeping closer to estimates of ‘neutral’ rates. I still expect both central banks to cut rates this year. However, reflecting the substantial uncertainty around the outlook for broader policy in the US under President Trump, I am more confident in my central forecast for the ECB than the Fed.

Fed: not in a hurry

As expected, the Fed kept rates on hold at 4.25 -4.5%.

Chair Powell did not give much away about what to expect in the next few meetings. The key part came in the opening statement: “With our policy stance significantly less restrictive than it had been, and the economy remaining strong, we do not need to be in a hurry to adjust our policy stance.” When asked specifically whether a March cut was on the table, one of his comments was to repeat that line around not needing to be in a hurry. More generally, they are still waiting on the data to guide them in what they should do.

There were some changes around the language on inflation progress in the statement, but Chair Powell said that these were more of a language clean up and not meant to send a signal. They continue to describe inflation as “somewhat elevated.” In the opening statement, Powell described both growth in economic activity and labour market conditions as “solid”. As before, they do not see the labour market as a source of significant inflation pressure at the moment.

Sounds like they still see themselves cutting rates again: The impression (putting to one side the December FOMC forecast projections) is still that they see themselves cutting again (even if, for now, they see policy as well-positioned); Chair Powell continued to describe monetary conditions as “meaningfully restrictive.” They do expect to see further progress on inflation, and they could then be in the position of making further policy adjustments, he said. On the labour market, he said that overall the data suggested it was broadly stable and in balance, but that this was a low hiring environment and they don’t need the labour market to cool any more. Powell also said that he thinks rates are meaningfully above neutral. However, not knowing for sure where neutral is and having cut 100bps already means it is appropriate not to be in a hurry to make further adjustments (i.e. rate cuts).

The Trump factor (wait and see): On Trump, tariffs, policy uncertainty and inflation risks, Powell had a few things to say. Key among those was probably the point that they are waiting to see what policies are enacted. They don’t know what will happen and he said they will patiently watch, seeing how it plays out. He did talk about elevated uncertainty in four areas (tariffs, immigration, fiscal policy and regulation), but also emphasised that uncertainty wasn’t unusual.

I’ve been expecting more rate cuts from the Fed this year, but under the new administration, I see the balance of risks as skewed towards more inflation and fewer rate cuts than I had pencilled in

“Think about the first few months of the pandemic,” said Powell. “That was uncertainty.” On immigration, he said that flows across the border had slowed very significantly, but that job creation had slowed too. He did say though that there was anecdotal information that some businesses were already finding it harder to get labour. On tariffs he said the range of possibilities is “very very wide”. He also pointed out that they don’t know how strongly it will transmit to consumers.

I’ve been expecting more (albeit slower) rate cuts from the Fed this year (three 25bp cuts), but under the new administration, I see the balance of risks as skewed towards more inflation and fewer rate cuts than I had pencilled in.

ECB: still on a rate cutting path

As expected, the ECB cut rates 25bps, bringing the deposit rate to 2.75%. Policymakers continue to see the disinflation process as “well on track”. Although domestic inflation “remains high” they still interpret this as reflecting a delayed reaction in wages and certain prices to past high inflation. In their view, “wage growth is moderating as expected”. Although headline inflation has risen most underlying indicators have been developing in line with a sustained return to the 2% inflation target. Their approach to policy remains the same. They “will follow a data-dependent and meeting-by-meeting approach”. The governing council is not pre-committing to a particular rate path.

Expecting to cut rates further: The impression from the ECB is still very much that rates are likely to be cut further. The governing council do not yet think rates are at neutral. For example, President Lagarde said that policy is currently restrictive. She said that it was premature at this point in time to have a discussion about the point where they have to stop. “We know the direction of travel….and this is the direction that we will take. At which pace, with what sequence, what magnitude will be informed by the data…and by the analysis.”

But not stepping up the pace either: There was no sense that they are preparing to step up the pace of cuts either. Lagarde pointed out that they have now cut by 125bps. She said that the decision around cutting 25bps at this meeting was unanimous and that “we did not even utter the two numbers 5,0”. She did not paint a pessimistic picture of the growth outlook either (albeit they still see the balance of risks as to the downside), including the line “recovery there is, stagflation there is not.” She said that although the fourth quarter of 2024 did see a stagnation of growth, it was just for one quarter.

More neutral analysis on the way: She said that on 7 Feb there will be a publication by staff on the neutral rate, although, “as you know it is a range… that does not give guidelines or a destination.”

In the meantime, sounding confident that inflation is on track: In answer to a question she said, “Yes we are confident that inflation will reach our target in the course of 2025” and that while domestic services inflation is still resisting and is wage sensitive, “all the [wage] indicators that we have at the moment are heading downward… and are confirming our confidence that wages in 2025 will be going down.”

Trump risks: US policy is clearly a source of uncertainty for the ECB but (somewhat similar to Fed Chair Powell) she pointed out that there are “rumours…statements…assumptions”, but that “we don’t have anything that is clear, tangible and can be inserted into the analytical work that the staff does”. She also said that it is “far more complicated” than this being inflationary/deflationary due to factors including possible re-routing of trade, retaliation etc. But that “all we know for sure is that it will have a global negative impact.”

I have been expecting the ECB to cut rates to 1.75% this year, so another 100bps. So far that seems a reasonable central case, but one that requires ongoing reassurance from inflation-related data, and there are plenty of sources of uncertainty this year that the ECB will need to contend with.

The fund manager view – Craig Inches, Head of Rates & Cash

The ECB  resumed where it left off in 2024 by cutting its interest rates by a further 25bps at its January 2025 meeting, bringing cumulative reductions of 1.25% in this cycle so far. And, as before, it was a consistent message that they are not committing to a pre-determined rate path but, rather, remain data (not datapoint) dependent. They remain confident that inflation is on a sustainable path towards their 2.0% target over the medium term, whilst acknowledging that services inflation is taking longer to abate than other constituents. However, Lagarde was convinced that falling wage settlements and loosening labour market conditions should contribute to labour intensive domestic services inflation declining.

On the issue of forward guidance regarding future policy decisions, Lagarde was perhaps more robust in her rebuttal than she has been historically, stating it would be “totally unrealistic” to give forward guidance, given the increased uncertainty arising from geopolitics and the potential for trade friction arising from new US administration. Several questions were posed regarding the potential impact of tariffs and the potential for retaliatory measures and the impact on ECB policy. Much like other central banks who have expressed a view so far, the response was that it is too early to provide an answer on this, not least because no concrete tariffs have been announced and uncertainty remains high – but it is clearly a factor that may have to be considered in future policy decisions. Lagarde was also somewhat defensive when questioned on the disappointing GDP figures in Q4 2024 for a number of the larger European economies, pointing out that the annual numbers for the year were positive. There were also a number of questions regarding the neutral rate of interest, R*, which Lagarde addressed by signposting a report due from ECB staff member to be published early next month. Whether this satisfies the markets demand for firmer guidance on what the neutral rate for Europe actually is, remains to be seen.

So where does the ECB go from here? Market pricing reflects the view that the ECB cuts again in March 2025. Given the unanimous decision this time, coupled with the acknowledgement that rates remain in restrictive territory and inflation remains on target to reach 2.0%, this seems reasonable. However, in reality, the euro area picture is maybe a little less clear than it was previously, given the potential for trade friction arising from tariffs that may, or may not, be imposed by the US. From our point of view as government bond portfolio managers, one thing that is perhaps more certain, however, is that this further source of volatility in global government bond markets will continue to present opportunities for active management.

The euro area picture is maybe a little less clear than it was previously, given the potential for trade friction arising from tariffs that may, or may not, be imposed by the US

Federal Reserve

At the recent committee meeting on 29 Jan 2025, the Fed decided to leave the target range for interest rates at 4.25% - 4.50%, which was fully expected by the market. All eyes were on the accompanying statement and press conference to look for clues as to what the FOMC will do next. What did we learn… not much other than the Fed are firmly sat on the fence! Lots of hawkish buzzwords were used such as “solid”, “strong” and “stabilized” in relation to labour, business investment and the housing sector. However, these were quickly negated with “patience”, “waiting to see” and “no hurry” in relation to inflation, government policy and interest rate cuts.

So what concrete information and views can we take away from this meeting ? We were informed that rates are still seen as restrictive by the committee, so we know that means future rate cuts towards neutral. They once again confirmed that they will not second guess government policy (and its potential impact on labour, inflation and economy) and that all eyes will be firmly on the data. And lastly, they inferred that temporary inflation increases from tariffs may be downplayed in favour of the likely future impact on growth and cost of living.

The market digested the information with a dovish tilt and we saw bond yields fall post meeting. The market is currently priced for two rate cuts in 2025, with the first of these coming in June 2025, followed by the second cut in December 2025. Our view is that the Fed will potentially need to cut faster than this profile as tariff exuberance may end up ‘Trumping’ growth in the second half of 2025 and future years. As such, in our strategies we continue to favour a long duration stance with a bias towards steeper yield curves.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.