Inflation battle stretches into 2025 on Trump uncertainty

Fed and Gulf central banks enter New Year in wait-and-watch mode

Fed chairman Jerome Powell said the central bank will be cautious about cutting rates after reducing its target by 25 basis points in December. AFP

The US Federal Reserve has entered the New Year with the last mile in its inflation battle stalled, as president-elect Donald Trump's policies add a new degree of uncertainty to the central bank's outlook.

After holding interest rates steady for more than a year, the Fed began its latest easing cycle in September with a jumbo 50-basis-point cut. Two further quarter-point cuts followed to bring their target range down to 4.25 per cent to 4.50 per cent last month, a full per cent lower than the start of 2024.

Central banks in the Gulf mirrored the Fed's decisions due to currency pegs, with the UAE Central Bank lowering its base rate to 4.40 per cent since September.

Saudi Arabia, the Arab world's largest economy, lowered its repo (repurchase agreement) rate and reverse repo rate to 5 per cent and 4.5 per cent, respectively. Central banks in Oman and Bahrain also lowered their rates to 5 per cent, while Qatar has issued three 30-basis-point cuts since September. Kuwait, whose economy is pegged to a basket of currencies including the dollar, also joined in.

But now, like earlier last year year, the Fed – and for that matter, the GCC – is in a wait-and-watch mode.

Sticky inflation, slower pace

Projections released by the US central bank in December showed officials expect to cut rates twice this year, half the amount they projected in September.

Bank officials believe the Fed funds rate will fall to 3.9 per cent by the end of 2025, and to 3.4 per cent in 2026 before climbing down to 3 per cent in the longer run.

The changes reflect the Fed's thinking that inflation will be firmer than previously thought. Services and housing costs have been particularly sticky for the central bank.

“The changes needed to be made because reality [demanded] it,” said Art Hogan, chief market strategist at B Riley Wealth. “The sticky part of the equation is [that] the last mile of inflation is taking longer than anyone would like and what they expected.”

Meanwhile, the labour market is holding up better than expected while economic growth remains robust. “The overarching sentiment is the Fed has to slow pace of rate cuts because the economy is too good,” Mr Hogan said.

Quest for neutral

Fed officials are not quite sure where the central bank's benchmark rate will end up. Officials are grappling with what is referred to as the neutral rate, which is the level where interest rates neither restrict nor stimulate the economy. The neutral rate is not a measure that can be directly observed.

Fed chairman Jerome Powell did not say what he believes the neutral rate is when asked by reporters on December 18, during the Fed's last policy meeting. He instead said, “we know it by its works”.

“I think we’re in a good place, but I think from here, it’s a new phase and we’re going to be … cautious about further cuts,” Mr Powell said.

Those remarks pointed to the general belief the Fed will slow its pace this year as it remains wary that cutting rates too quickly could reignite inflation.

Trump brings new uncertainty

However, the greatest degree of uncertainty the Fed faces is Mr Trump. The incoming president made headlines in the run-up to the 2024 election, promising to impose universal tariffs, mass deportation of migrants and an extension of his 2017 tax cuts that most economists argue are inflationary.

US Fed chief Jerome Powell hints at interest rate cuts

00:29

Mr Powell acknowledged some officials took Mr Trump's policies into consideration when pencilling in their interest rate and inflation forecasts although it is still too soon to say what effect they will have.

“The point about uncertainty is it’s kind of common sense thinking that when the path is uncertain you go a little bit slower,” he said.

Treasuries

That uncertainty has already crept into the bonds market. The 10-year Treasury yield has risen by nearly 100 basis points to its current rate of 4.585 per cent since the Fed began cutting rates on September 18. Those changes reflect higher inflation expectations and persistent budget deficits.

Arif Husain, chief investment officer for fixed income at T Rowe Price, said in an October report that yields on the 10-year US Treasury bond could climb to 5 per cent early this year.

Rising Treasury yields have put people looking to take out a mortgage or buy a new vehicle in a difficult place because those costs are more affected by longer-run rates as opposed to Fed policy.

The average mortgage for a 30-year fixed loan rose to 6.72 per cent for the week ending December 19, according to mortgage buyer Freddie Mac.

“Many homeowners who locked in mortgage rates at record lows are coming to terms with the reality that sub-3 per cent rates may not return soon,” Kara Ng, chief economist at real estate site Zillow, wrote in a note.