As described in our last Fixed Income Quarterly, an economy in a quasi-stagflation environment (low but positive growth and persistently high inflation) poses a significant challenge for any central bank. Specifically, the Federal Reserve (Fed), which operates under a dual mandate, faces an almost inherently systemic conflict between its objectives. Which goal is more important: achieving full employment or maintaining inflation at target levels?
At present, the Fed appears to be prioritizing labor market risks over inflation concerns. As expected, it decided to implement an interest rate cut both in October and December. Despite consumer prices continuing to rise above the target level, the recent disappointing labor market data left the Fed with little choice but to proceed with another rate cut. Nevertheless, Fed Chair Jerome Powell simultaneously hinted that the Fed might return to its more conservative monetary policy stance, essentially adopting a wait-and-see approach.
The reason for this potential return to a cautious stance, in our view, is the increasingly evident K-shaped development in the US economy. Economic growth is no longer uniform across all population groups. While some industries, households, and businesses are enjoying growth and prosperity, others are sinking deeper into financial uncertainty.
A K-shaped economic development refers to a dynamic where different economic groups develop in opposite directions:
Upper K-line: High-income earners, large corporations (e.g., the "Magnificent 7"), skilled workers, and capital market participants. These groups benefit significantly, experiencing growing wealth and stable employment.
Lower K-line: Low-skilled workers, small businesses, and financially vulnerable households. These groups face increasing challenges, experiencing long-term unemployment, stagnating wage or even declining incomes.
These diverging trends create unique challenges for the Fed, as its policy decisions traditionally rely on aggregate indicators such as GDP, unemployment rates, and inflation. However, K-shaped dynamics are often hidden behind these aggregate measures.
The Fed heavily relies on the state of the labor market to guide its monetary policy. While the current unemployment rate remains at very low levels, new job creation is concentrated in only a few sectors. In a K-shaped growth path, the official unemployment rate can be misleading. For instance, highly skilled workers tend to find new jobs quickly, which pulls the overall unemployment rate down. At the same time, structurally disadvantaged groups remain unemployed for disproportionately long periods.
A K-shaped economic development affects inflation unevenly. Households in the upper K-line tend to increase their consumption, purchasing more financial and tangible assets, which creates upward pressure on asset prices. In contrast, households in the lower K-line are more cautious, delaying consumption or taking on more debt, which leads to reduced price pressure.
K-shaped development can also lead to parts of the economy overheating while others continue to struggle. Strong sectors, which are highly sensitive to monetary easing (e.g., benefiting from cheap credit and rising asset prices), may experience rapid growth, while weaker sectors derive only marginal benefits from low interest rates.
A K-shaped economic trajectory presents conflicting signals for central banks in general, particularly for the Fed, which operates under a dual mandate. Strong sectors may argue for interest rate hikes to prevent overheating or asset bubbles, while weak sectors call for lower interest rates to support employment and income growth.
This divergence forces the Fed to conduct a deeper analysis of economic developments across industries, demographic groups, education levels, and age brackets. These complexities make it more challenging to determine when the economy has reached the “maximum employment” required by the Fed’s mandate.
The Fed also faces the question: Which type of inflation should it combat or tolerate? Asset price inflation (e.g., stocks, real estate, cryptocurrencies, gold) or consumer price inflation, which is often unevenly distributed across product groups?
A uniform inflation target of 2 percent thus becomes an imperfect guiding star. The risk that monetary policy measures could create bubbles increases in strong sectors before weaker sectors have even recovered.
We believe a more nuanced approach to monetary policy is needed—something that is difficult to achieve with a single policy interest rate. The traditional interest rate path becomes less effective. As a result, we believe the Fed must adopt greater flexibility, pausing more frequently and remaining prepared to reverse course, as seen in the current environment.
The K-shaped economic development places the Fed in a dilemma: with only one interest rate at its disposal, it must respond to an economy moving in opposite directions. While the Fed cannot fully resolve this divergence, it must increasingly account for these dynamics in its monetary policy decisions, in our view.
And as if this balancing act weren’t difficult enough, the Fed is also facing mounting pressure to implement a politically motivated rate cut. At the same time, it must strive to maintain its credibility and independence.
Despite the increasingly significant uncertainties described above, we maintain our assessment that the Fed will lower its policy rate further by two additional rate cuts in the first half of 2026. This would likely mark the end of the rate-cutting cycle by mid-2026, with policy rates stabilizing in a neutral range of 3% to 3.25%.
However, it is precisely these uncertainties mentioned above that market participants must also take into account in their decisions, leading them to demand compensation in the form of a higher term premium. As a result, we see only limited potential for price gains at the long end of the US yield curve, particularly as we approach the end of the rate-cutting cycle.
The European Central Bank (ECB) appears relatively confident in its positioning for the coming quarters. This is despite the fact that economic stimulus measures in Germany of historic proportions—in the form of defense and infrastructure spending as well as tax relief measures—are expected to support growth in 2026. Additionally, energy prices could trend upward again due to increasing global demand for AI data centers. However, this is unlikely to have a significant impact in the first half of the year, which is why we believe the ECB will keep its policy rate unchanged until mid-year. Similar to the US, we see little room for capital gains at the long end of the EUR yield curve.
After the Bank of England (BoE) kept its policy rate unchanged in November, the market is now fairly confident that the BoE will lower its policy rate in December. This expectation is supported by Chief Economist Huw Pill’s statement that there are “increasing signs of progress in disinflation toward the 2 percent target for consumer price inflation.” Although recent data from the real economy has been largely disappointing and the risk of further economic slowdown remains, the long end of the yield curve is likely to face pressure from oversupply and may not follow the downward trend of short-term interest rates.
Bank of Japan (BoJ) Governor Kazuo Ueda indicated in mid-November, during his meeting with newly elected Prime Minister Sanae Takaichi, that the BoJ will continue its course of raising interest rates. This aligns with our long-held view that the BoJ will gradually increase its policy rate to tighten its accommodative monetary policy in light of rising wages. However, the next rate hike is more likely to occur in January rather than December, as Takaichi has expressed her preference for a cautious approach by the BoJ when raising rates. She has also emphasized the importance of monetary policy for a strong economy. Additional upward pressure on long-term interest rates is expected to stem primarily from the ambitious economic stimulus package anticipated from the new government.
Our assumption that the US labor market will continue to weaken could prove to be incorrect, which could lead the Fed to place greater emphasis on controlling inflation than expected. As a result, the rate-cutting cycle could end earlier than anticipated, causing the US yield curve to flatten again.
In Europe, Germany’s expansionary fiscal policy could fall short of expectations, leading to disappointment. This could prompt the ECB to unexpectedly lower interest rates below 2 percent, with yields on Germany’s 30-year government bonds potentially stabilizing below 3 percent.
In the United Kingdom, inflation could prove to be more persistent than expected, limiting the Bank of England’s ability to implement further rate cuts and reducing the attractiveness of long-term bonds even further.
Our conviction that the BoJ will continue tightening policy rates could be incorrect due to the influence of the new Prime Minister, Sanae Takaichi. She has stated that “the ultimate responsibility for macroeconomic policy—including fiscal and monetary policy—rests with the government,” and emphasized that “the BoJ must maintain sufficient coordination with the government.”
