Cut, pause, hike – central bank monetary policy cycles are no longer in sync. While the Federal Reserve (Fed) is expected to resume its rate-cutting cycle, the European Central Bank (ECB) may implement one final cut. Meanwhile, the Bank of England (BoE) is very likely to pause, and the Bank of Japan (BoJ) is expected to continue hiking rates in 2025.
These asynchronous central bank policy paths could be an early indication that the US and its central bank are gradually losing their hegemonic role in the long term. This shift could be driven by increasing pressure on the Fed’s independence and the escalation of US protectionism under the "America First" policy. In the short term, however, much of the divergence in monetary policy can be attributed to President Donald Trump’s tariff policies, which many view as misguided.
Economic theory suggests that tariffs will result in slower growth and higher inflation, effectively generating a negative supply (or stagflationary) shock for the country imposing them, in this case, the US. In response, central banks with a singular mandate of price stability, such as the ECB, BoE, or BoJ, would typically tighten monetary policy to counter inflationary pressures.
However, the Fed operates under a dual mandate: price stability and full employment. This dual mandate complicates its response to tariffs compared to central banks with a singular focus.
Consequently, the Fed’s optimal response to a negative supply shock is a balanced approach – one that mitigates the inflationary effects of tariffs while minimizing disruptions to the labor market. In theory, this would result in a mildly hawkish bias.
In practice, however, this explains why the Fed shifted from its dovish stance, which had prevailed since mid-2024, to a more balanced position by early 2025. Since then, the Fed has maintained a neutral stance, pausing its easing cycle through the present.
The US economy is now evolving in line with the theory outlined earlier, following President Trump's decision to increase the average import tariff rate from below 3% at the end of 2024 to more than 18% at the time of writing. In response, businesses across the US have slowed hiring amid heightened uncertainty, as highlighted in our last Fixed Income quarterly report. Meanwhile, the rising costs of imported goods due to tariffs are gradually being passed on to US consumers.
Initially, preemptive consumer spending helped the US economy remain resilient through Q1 and Q2. However, the economy now appears to be on the brink of stagflation – a challenging scenario for the Fed as it seeks to balance its dual mandate of price stability and full employment. Fed Chair Jerome Powell has repeatedly stated that monetary policy remains "in a good place," but with inflation proving stickier than anticipated and cracks beginning to emerge in the labor market, the Fed faces a critical decision. Should it prioritize achieving price stability or supporting full employment? This pressing question weighs heavily not only on FOMC members but also on market participants navigating this uncertain environment.
Consumer inflation expectations remain elevated due to the impact of tariffs, which effectively function as a tax on consumers. This "tax" reduces disposable income, thereby dampening consumption. According to the Yale Budget Lab, real GDP growth is projected to be 0.5% lower in both 2025 and 2026 compared to a baseline scenario without tariffs. Meanwhile, the unemployment rate is expected to rise by 0.3 percentage points by the end of 2025 and by 0.7 percentage points in 2026 as a result of the tariffs. These projections are based on an estimated average effective tariff rate of approximately 18% after accounting for consumption shifts – the highest level since 1934, according to their analysis.
In our view, an unemployment rate exceeding 4.5% would compel the Fed to implement several rate cuts, even if core inflation (i.e., the core PCE deflator) remains above 3%, as projected by the Fed.
This scenario carries significant implications. First, inflationary pressures are unlikely to ease if the Fed resumes cutting rates. Returning to an easing cycle while inflation continues to drift further from the Fed's 2% target would signal that the central bank is deeply concerned about the labor market and the broader economy. Meanwhile, the White House has been advocating for lower interest rates to reduce the government's growing debt-servicing costs. However, it is President Trump's erratic and misguided trade policies that have largely contributed to the current economic challenges.
While monetary policy easing in response to a weakening job market may be warranted, it poses a potential risk to the Fed's credibility. Cutting rates against the backdrop of a cost-of-living increase, record-high equity prices, abundant liquidity in the market, and mounting political pressure from the President and his administration could undermine confidence in the Fed's independence and decision-making process.
The credibility of US institutions is a key driver of investor confidence in US assets. Any erosion of trust in the Fed or the reliability of economic data could lead to higher risk premiums for US assets. At the same time, inflationary pressures may continue to build, not solely due to tariffs but also because of the Fed's accommodative monetary policy. This dynamic could further contribute to a higher term premium on longer-dated US Treasuries, ultimately leading to a bull steepening of the yield curve.
A loss of credibility in US institutions could weaken the safe-haven status of both the US dollar and US Treasuries, potentially triggering widespread economic and financial repercussions.
Against this backdrop, we are making a slight adjustment to our long-standing forecast. We now expect the Fed Funds Target Rate to reach 3.75% by year-end, down from our previous estimate of 4%, while maintaining our projection for the 30-year US Treasury yield at 4.75%. We expect the Fed to implement its next interest rate cut in September, followed by additional 25-basis-point cuts at each of the remaining meetings in 2025.
The economic theory referenced earlier suggests that tariffs create a negative demand shock in targeted countries. If the affected country chooses not to respond with retaliatory tariffs, the optimal central bank response would typically involve easing monetary policy, particularly if the targeted country is a small and open economy.
While the Eurozone, as a large economic bloc with significant size and economic influence, does not meet the criteria of a small and open economy, individual member states like Germany are more vulnerable. Germany, with its export-oriented business model and status as the largest exporter of goods to the US among all Eurozone members, is particularly impacted by tariffs. These tariffs reduce export demand, posing challenges to Germany’s economy despite the broader Eurozone’s resilience.
The latest Eurozone trade balance figures may already provide evidence supporting this theory of a demand shock, although it's still too early to tell. After recording the largest trade surplus with the US in history back in March – just before the implementation of tariffs – Eurozone exports to the US fell by 7.6% year-over-year in June and 12% year-over-year in July.
While trade balance figures are often highly volatile, the impact of tariffs on Eurozone growth could be more substantial than anticipated by the ECB and market participants. Several factors could weigh on exports and act as a disinflationary force in the Eurozone. These include a stronger euro, heightened uncertainty around global trade, and intensified competition from China, which is redirecting exports – previously destined for the US – to the Eurozone and other global markets, as outlined in our last Fixed Income quarterly.
Market participants have finally aligned with our long-standing view that an ECB deposit rate below 2% is unlikely, as we discussed in the previous Fixed Income quarterly. At the moment of writing, less than half of a 25-basis-point rate cut is priced in for the remainder of 2025. Following our recognition of a more aggressive rate-cutting trajectory by the Federal Reserve than previously anticipated in June, we reiterate the possibility that both the market and our own projections may be underestimating the likelihood of a further ECB rate cut to 1.75% in September.
That said, we maintain our view that yields on 30-year German federal bonds could bottom out around 3% and finish slightly above this level by the end of 2025, resulting in a modest bull steepening of the yield curve.
The BoE and the BoJ are in the same boat as the ECB with respect to tariffs. However, a key distinction is that, unlike in the Eurozone, inflation in both countries remains significantly above the target levels set by their respective central banks.
The BoE faces a significant challenge as inflation rises to nearly double its 2% target. July's inflation data revealed a headline figure of 3.8%, up from 3.6% in June. Persistently high, above-target inflation for nearly six consecutive years risks undermining the BoE’s credibility and de-anchoring inflation expectations. Following the resolution of the "Liberation Day" uncertainty spike, as reflected in improving PMI figures, GDP growth is expected to recover. After the BoE's rate cut in August to 4%, there appears to be limited room for further rate cuts this year, a view shared by market participants and our own analysis.
A more aggressive rate-cutting trajectory by the Fed than previously anticipated in June has implications for our outlook on the BoJ’s monetary policy. While we previously projected a key interest rate of 1% by the end of 2025, we now anticipate only one additional rate hike for the remainder of the year, which would bring the policy rate to 0.75% in October. We have also slightly adjusted our forecast for 30-year Japanese government bond yields, lowering our year-end 2025 projection from just below 3.5% to slightly above 3.25%. This revision comes despite domestic demand in Japan remaining resilient, even in the face of higher US tariffs.
The Swiss National Bank (SNB) has repeatedly emphasized the high bar for reintroducing negative interest rates. While experience has shown negative rates can be effective, they also entail risks for banks, investors, and households that could create long-term distortions. After six consecutive rate cuts in response to easing inflation, the SNB’s policy rate currently stands at 0.00%, and officials have not ruled out moving into negative territory again.
Despite calls from some foreign analysts for renewed monetary easing following the tariff shock – 39% duties on Swiss exports to the US – domestic economists remain skeptical. Growth will slow, and job losses in exposed industries are expected, but few see a recession. Moreover, lowering rates would do little to address tariffs, which are a structural rather than monetary problem. With inflation at just 0.2% in July and likely to edge higher later in the year, the SNB retains policy space but little immediate justification for cuts.
For now, the consensus expectation is that the SNB will hold rates steady at 0.00% through its September policy meeting, with the risk of negative rates postponed at least until year-end. Alternative tools, such as foreign exchange interventions, remain available but carry political risks, particularly amid US accusations of currency manipulation. In this environment, the SNB appears inclined to wait and rely on Switzerland’s relatively resilient domestic economy, rather than rushing back into unconventional policy.
