Last Friday, the US dollar index retreated from a two-year high as the Fed's favorite inflation indicator cooled, which led to a resurgence in expectations of rate cuts. As of now, the US dollar index is quoted at 107.72.
US PCE and core PCE data were lower than expected across the board, and traders increased their bets on the Fed's rate cut in March next year.
Fed Dynamics:
Fed-Daly: The Fed is very satisfied with the forecast of two rate cuts in 2025;
Williams: Economic growth is expected to slow to about 2% next year, and the current policy state is good, but slightly restricted;
Goolsby: My forecast is that the interest rate path in 2025 will be slightly lower. Interest rates may fall sharply in the next 12 to 18 months;
Hamark: The vote against the rate cut was due to concerns about inflation. The scale of the Fed's RRP usage has dropped to less than $100 billion.
Trump said on social media on the 20th that the EU should reduce its "huge" trade surplus with the US by purchasing large amounts of US crude oil and natural gas, otherwise it will impose tariffs on the EU. A spokesman for the European Commission in charge of trade affairs responded that he was ready to discuss with Trump how to further strengthen EU-US relations.
Trump asked the Panama Canal to reduce charges for US ships, otherwise "the canal will be returned to the United States."
Russian President Putin: Ready to restore relations with the United States and other Western countries without harming the interests of the country. Trump: May meet with Putin next year.
Qatar warned: If the EU implements the "Corporate Sustainability Due Diligence Directive", Qatar Energy Company will lose 5% of its revenue, or Qatar may stop supplying natural gas to the EU.
Palestinian official: Gaza ceasefire negotiations have been completed by 90%. Israeli sources: Gaza ceasefire negotiations are not close to reaching an agreement. Sources said that Israel and Hamas have reached an agreement on four major issues in the negotiations.
The Houthi armed forces announced the use of hypersonic ballistic missiles to attack Israeli targets. The Israeli army's preliminary investigation showed that multiple interceptor missiles failed to shoot down ballistic missiles from Yemen.
A residential building in Kazan, Russia was attacked and exploded, three airports were closed one after another, and the local government entered a special working state. In addition, Russian media reported that Kursk State was attacked by Ukrainian missiles, which has caused 5 deaths and 26 injuries.
Biden signed an emergency appropriations bill to prevent the US government from "shutdown"; the US Senate and House of Representatives voted to pass the bill.
Barclays Bank said that one of the factors that may keep US interest rates high is US (inflation) policy. At the December meeting, some FOMC participants apparently began to reflect expectations of tariffs in their inflation forecasts. In addition, even among those who did not adjust their official forecasts, many now believe that the balance of inflation risks is tilted to the upside. Although Powell did not clearly answer the extent to which the Fed prefers to look through tariff-related price level increases, we believe that it will be challenging for the Fed to continue to cut interest rates when tariffs are expected to cause inflation to rise in the second half of 2025, especially against the backdrop of rising inflation rates in recent years. We expect the Fed to pause rate cuts after June next year and resume rate cuts around mid-2026 after tariff-induced inflation pressures dissipate. In our baseline, we expect two 25 basis point rate cuts in 2026, with a terminal rate of 3.25-3.50%.
The market did not enter the holiday season gently. On Wednesday, the S&P 500 recorded its second worst trading day since 2024, with interest rates falling sharply and the VIX index soaring above 25 points. The reason is of course the Fed, which surprised the market with hawkish distortions in its statements, dot plots and communications. Coupled with slightly more dovish signals from the Bank of England and the Bank of Japan than expected, the Fed's hawkishness has pushed the dollar stronger, and the dollar index continues to break out of the trading range of the past two years.
Does this mean that the Fed's approach has changed fundamentally? We think the answer is mostly "no". Despite this, we still expect the Fed to cut interest rates only twice next year, and there will be differences between the Fed and other major central banks. However, this depends on economic fundamentals and US policies characterized by US exceptionalism, rather than a shift in the Fed's reaction function. In turn, incoming data and policy news are more important than ever.
Jinshi Data reported on December 21 that the Federal Reserve raised the federal funds rate target by 0.5 percentage points at the end of 2025. Citi economist Andrew Hollenhorst believes that the Fed may be caught in a situation where he is at a loss. As the core PCE rose 0.1% month-on-month in November, price increases are slowing, and the Fed's final rate cuts may exceed current expectations. "In our base case, a softening labor market leads to rate cuts at every subsequent Fed meeting." This view is contrary to market expectations that the Fed will pause rate cuts in January. "But even if we are wrong, sideways unemployment and slowing inflation are enough to justify rate cuts at every meeting except January at least."
The Bank of Japan decided to keep interest rates unchanged at its meeting on Thursday. Governor Kazuo Ueda explained at a subsequent press conference that the central bank chose not to raise interest rates for the time being due to the lack of information on wage growth in next year's "Spring Fight" (Japan's spring wage negotiations) and uncertainty about the economic policies of the new US administration and its impact on Japan. But he also said that this does not mean that the Bank of Japan will not raise interest rates, but will decide the timing of the rate hike after a deeper understanding of these factors. He also admitted that delaying rate hikes may increase the risk of falling behind the situation.
Kazuo Ueda also pointed out that the Bank of Japan does not believe that the neutral interest rate is lower than previously assessed, but plans to gradually raise interest rates over a longer period of time with a moderate increase in underlying prices. Based on the Bank of Japan's decision and Kazuo Ueda's speech, we believe that the Bank of Japan will still choose to raise interest rates at the January meeting. However, if the branch manager meeting before the Bank of Japan's January meeting believes that the wage growth momentum of small and medium-sized enterprises is insufficient, or there is great uncertainty about the economic policies of the new US government and their impact, and the Bank of Japan lacks sufficient confidence in the economic growth outlook, then the rate hike may be postponed to March or April.
After the announcement of the Fed's interest rate decision, we made some adjustments to our expectations for the Fed's interest rate cuts next year because the results were more hawkish than we expected. We believe that the Fed will cut interest rates in March and June next year, rather than in January, March and May as before. At the press conference, Powell also said that the hawkish shift in the economic forecast this time actually included some participants' consideration of the potential impact of trade, immigration and fiscal policies brought about by the new government. They believe that the implementation of the new policy will lead to more stubborn inflation, which has prompted them to be cautious about the pace of interest rate cuts. However, we have not made any changes to our expectations for a rate cut in 2026, so the terminal interest rate level of this round of the Fed's easing cycle should be 2.6%, slightly higher than the previous 2.4%.