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Written by: David Stonehouse | AGF
At the beginning of 2024, economists and market observers were increasingly confident that the disinflation trend that began the prior year would continue, allowing central banks to shift their focus in favour of easing monetary policy. This view was bolstered by the U.S. Federal Reserve’s (Fed) pivot toward a more dovish perspective as articulated by Fed Chair Jay Powell in December of 2023. Lingering concerns about the potential for a recession, exacerbated by gradually rising unemployment rates in the U.S., also supported the notion that central banks would shift to a more accommodative stance. Indeed, such was the optimism surrounding this scenario that global markets in January were pricing in almost seven 25-basis-point rate cuts by the Fed in 2024.
However, a combination of resilient economic growth and stickier than expected inflation forced markets to revise their rate cut expectations. In the end, the Fed only delivered about half the easing anticipated at the beginning of 2024, and many other central banks, constrained more by stubbornly slow disinflation than solid growth, followed suit. Canada was an exception, as faster disinflation, more rapidly rising unemployment and underwhelming GDP growth allowed the Bank of Canada (BoC) to meet expectations entering 2024 of five to six rate cuts.
So, what’s in store for 2025? Central bank observers have embraced the strong U.S. economy thesis, and investor surveys indicate that fears of a recession are at the lowest levels in the past few years. In addition, the election of Donald Trump as the next U.S. president has caused rates markets to reassess prospects for both growth (due to potential tax cuts and deregulation) and inflation (due to potential tariffs and deportations). As a result, only two or three rate cuts have been pencilled in over the next year.
Central bank observers have embraced the strong U.S. economy thesis, and investor surveys indicate that fears of a recession are at the lowest levels in the past few years.
However, history has shown that the global markets rarely get central bank rate forecasts right. In fact, in the case of the Fed, the market has swung between high and low rate cut expectations three times in the last 18 months as inflation and economic data fluctuated. It would be more of a surprise if the current consensus were realized than not. With that in mind, current optimism about U.S. growth prospects, with attendant modest rate cut assumptions, may be somewhat misplaced. It is reasonable to postulate that the Trump administration will be quicker to implement the part of its agenda that can be enacted by executive order without Congressional support. These items include tariffs and deportations, both of which have the potential to restrain growth and drive up the U.S. dollar, which could help offset any inflationary impact. A pro-energy policy, also at least partially within the purview of executive order, could also dampen inflation. This outcome may cause markets to reprice a more aggressive path of rate cuts in the early part of 2025, which is not the current consensus. Conversely, later in 2025, the Republican sweep of Congress makes an extension of the 2017 Trump tax cuts more probable, potentially with additional corporate tax cuts. Deregulation is also likely to pick up steam later in the year. This scenario could cause the pendulum to swing back toward fewer rate cuts as 2025 progresses, and if growth and inflation were to really accelerate, a premature end to the easing cycle (or even rate hikes) could be possible late next year. In sum, while the timing and size of rate cuts are likely to ebb and flow, we believe the Fed will remain on an easing path well into 2025.
The BoC is already closer to its long run neutral rate than the Fed and has already cut rates more aggressively. Since it’s farther along in its easing cycle, it may well stop lowering rates sooner than the Fed, especially if housing prices and/or economic growth start to pick up again.
One other thing for the Fed to consider is fiscal policy. Deficits are likely to remain high, so the Treasury will have to issue substantial amounts of debt, but the mix of T-bill and bond issuance will be key. This could have an impact on the Fed’s quantitative tightening program. Regardless, the Fed is likely to wind down quantitative tightening in 2025 depending on the amount of liquidity and reserves in the system.
The outlook for the Bank of Canada is somewhat different, although some further easing should occur just as in the U.S. The BoC is already closer to its long run neutral rate than the Fed and has already cut rates more aggressively. Since it’s farther along in its easing cycle, it may well stop lowering rates sooner than the Fed, especially if housing prices and/or economic growth start to pick up again. Early signs of improvement on that score as we near the end of 2024 support that view.
Finally, we believe monetary policy is likely to diverge in the rest of the world. Europe’s prospects appear to be among the weakest given trade wars, geopolitical conflicts, little population growth and low productivity, so the European Central Bank, Bank of England and others like the Swiss National Bank and Sweden’s Riksbank could continue cutting policy rates. The People’s Bank of China (PBOC) may continue to ease policy in an attempt to revive the economy and combat potential tariffs, but the Chinese Communist Party is mindful of past episodes of over-stimulus, which may keep PBOC easing at a more moderate pace. The Bank of Japan is likely to raise rates in the face of somewhat higher inflation, along with a desire to continue moving away from the zero percent interest rate policy of the past decade. Lastly, Emerging Market rates may vary based on local circumstances, with some hiking rates in the face of high inflation while others reduce rates to stimulate more growth. In sum, we anticipate the prevailing backdrop globally is for lower policy rates as we enter 2025, which should be supportive for economies and capital markets, but the path is likely to have numerous twists and turns as the year unfolds.
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