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But US interest rates to dominate global markets in the near term.
Welcome to our readers of the Brief. QIC’s Economics & Research Team hope that you enjoyed your festive break and we’re glad to see you back. And there is no time to rest as the year begins with a stream of events lining up over coming weeks. Next week, we see Donald Trump inaugurated as President and, presumably, launching policies immediately.
Federal elections are looming in Germany, Canada and, of course, Australia. In each case, progressive left leaning incumbent governments are being challenged by increasingly populist right leaning oppositions. Central Banks are also in the picture, with question marks over the direction of policy and a particular focus on the next move by the US Federal Reserve (Fed). Closer to home, the Reserve Bank of Australia is facing a “live” meeting when they resume policy meetings in February, following their summer break.
Encouragingly, an Israel/Hamas truce proposal looks like it might succeed in bringing peace to Gaza. Notwithstanding this latest good news, the theme dominating the economy and financial markets over the last quarter of 2024 and continuing into the New Year is the rise and rise of global interest rates driven by the US bond market. Amazingly, despite 100 basis points (bps) of rate cuts by the Fed between September and December 2024, 10-year US Treasury yields rose by around 100 bps. The Fed allowed the policy rate to drop as inflation moderated, while the bond market fixed its gaze on the ongoing strength of the economy and the likely impact of Trump Administration tariffs on domestic prices.
How does the Fed play this conundrum of gradually easing inflation vs a hot economy and tariff hikes? In the near-term, the path for the Fed is very clear. A pause by the Fed at their January meeting is all but guaranteed. While recent monthly core inflation readings have been benign, ongoing solid GDP growth and a surge in employment growth in December suggests that the Fed will pause in January and wait for more evidence before embarking on further cuts.
The timing and pace of potential future rate cuts will be heavily data dependent, particularly around the inflation outlook and labour market developments. Here the policies that President-elect Trump delivers, particularly around tariffs and immigration, will be crucial. Trump’s threat of a 60% tariff on Chinese imports and a universal 10% tariff on all imports from other countries, as well as the deportation of 11 million undocumented workers, would represent a significant supply side shock for the US economy. This would lead to a sharp surge in inflation, which the Fed may respond to with higher interest rates to prevent unanchoring inflation expectations.
However, as was the case in Trump’s first term, we expect Trump to dial back on his rhetoric. Ultimately, we expect Trump will lift tariffs on all imports from China to 25% and introduce modest targeted tariffs on selected critical products from other trading partners, while cutting immigration by 1.3 million (i.e. 0.1% p.a. lower population growth over four years). Under such a scenario, the impact on core US inflation rates will be muted at around 20bps by late 2025 and would not permanently derail the downward trend in inflation. Incorporating these tariffs, our base-case expectation is for core PCE inflation to fall from around 2.8% currently to 2.3% by the end of 2025 and 2.0% by the end of 2026.
US economic growth would likely slow from the strong pace seen in 2024 due to heightened trade uncertainty and cutbacks to Biden’s IRA spending, with year-ended growth expected to ease to around a 1¾% pace by late 2025. In a reverse pattern to Trump’s first term, we expect Trump will initially focus on policies (trade/immigration) that will prove a headwind to growth in 2025, with the more stimulatory impacts from tax cuts not expected until 2026.
With upside risks around inflation building given the uncertain impacts from Trump’s policies, we expect the Fed to proceed in a cautious manner. We expect two rate cuts by the Fed in 2025, with the next not occurring until June once a clearer picture of the tariff policies emerges and a second cut in December 2025. With inflation continuing to fall towards target next year, we expect one or two rate cuts in 2026 to take the US Federal fund rates to around 3¼-3½%, close to our view of the long-run neutral rate.
While our baseline outlook remains consistent with a soft-landing for both the US and global economies, the risks are skewed to the downside given the potential for more damaging trade wars and heightened geopolitical uncertainty during 2025.