US growth has remained resilient, though so has inflation. With US growth-inflation risks seemingly in balance, the US Federal Reserve has put monetary policy on hold. The interest rate path looks likely to remain high before moving lower later, despite some market talk about the Fed making a rate hike its next move. The bar for a policy reversal is high, in our view.
Listen to the article
The next interest rate move
US jobs and spending data since December 2024 have erased the recession fears we saw last summer, though more recent retail sales and services purchasing manager index (PMI) data point to a slowdown in activity. With (core) inflation on a trajectory towards the Fed’s 2.0% target, the leap from cutting to hiking rates is a big one, in our view.
While inflation has been sticky, most members of the Federal Open Market Committee (FOMC) still see the current level of the fed funds rate as ‘meaningfully restrictive,’ as the December meeting minutes showed.
Fed Chair Jerome Powell last week reiterated that ‘there is no need to rush on interest rate cuts’ – in other words, maintaining the current level of policy rates should continue to exert downward pressure on inflation.
Ruling out more rate cuts this year, however, is distinct from reversing the policy and raising rates. A reversal would mean not just one or two rate hikes, but a series of increases. The bar is high because the data so far shows that US economic growth and the labour market are not so strong as to threaten a revival of inflation. Wage inflation has remained in the 3.5%-4.0% range, with total labour cost growth moderating (see Exhibit 1). Labour productivity has also improved, which helps to cap inflationary pressures (see Exhibit 2). It would require several months of more robust economic data to change the Fed’s view on the trajectory of inflation and the need for tighter monetary policy.
What about tariffs?
Tariffs are transitory negative supply shocks, like increases in oil prices. They are inflationary in the short term but tend to hurt economic growth over time. If the Fed looks through the transitory shock, then as long as inflation expectations remain anchored, it could resume cutting rates once a slowdown in GDP becomes evident.
The prospect of reciprocal tariffs is another risk to economic growth and inflation. This has not been fully reflected in the markets as the tariff picture remains blurry. The January US retail sales slump (-0.9% month-on-month; -0.4% excluding autos, the worst in a year), and the latest Senior Loan Officer Opinion Survey, which reported tighter lending standards and weaker commercial loan demand, highlight soft spots in the economy that a tariff war could aggravate.
Meanwhile, there may not be a strong fiscal impetus, as had been expected, to push up inflation and interest rates. That is because a complicated budget reconciliation process in Congress could take many months, especially when the Senate and the House of Representatives have different fiscal strategies. The new Department of Government Efficiency (DOGE) could also be seen as a risk to growth because cutting spending is contractionary in the short term.
Investors may take some comfort from equity market performance during the first Trump trade war. It seems that the announcement of tariffs had no lasting effect on US equities (see Exhibit 3); what mattered more were policy and economic fundamentals.
The AI shock
The launch of Chinese artificial intelligence models has put China’s tech development back on investors’ radar. These models could accelerate the adoption of open-source models and create a positive productivity shock in the global economy that would be positive for equities and supportive of a moderating inflation trend over the long term.
AI-related news is boosting stock prices – see Apple’s development of AI features with Alibaba. Hong Kong’s Hang Seng Index has been riding high on AI news. It has gained 22% since the low point in mid-January partly on optimism that Chinese AI models will boost the tech sector, which has been badly battered since 2021.
Crucially, last week’s meeting between Chinese President Xi Jinping and leaders from China’s private sector technology, AI, robotics, new energy, e-commerce, and semiconductor companies signalled renewed policy support for the country’s private/tech sector.
When President Xi met private companies in early November 2018 amid the Sino-US trade war, a series of measures – including tax cuts and credit expansion for small & medium-sized enterprises – quickly followed. Chinese stocks bottomed out about a month after the meeting and staged a two-year rebound through 2021 (though as always past performance is no guarantee of future results).
What’s happening this week?
Later this week, the US will see headline and core personal consumption expenditures (PCE) inflation data for January. The market is expecting slightly lower prints of 2.4% and 2.6%, respectively, due to favourable base effects.
In Europe, the ECB will release (on 27 February) its January monetary policy meeting minutes, which should provide clues about its future policy moves. The market is expecting the ECB to cut the depo rate by 25bp at its meeting on 6 March.
The final estimate for fourth-quarter German GDP, February labour market data, and the latest Ifo business survey will also come out this week.
