A couple of months ago, it appeared as if 2025 might be the most remarkable year for international macroeconomics in many decades. Many economies were heading into what looked like a steady state.
Inflation in leading economies was heading sustainably back towards central banks’ targets, labour markets were pretty much at full employment and interest rates were finding a neutral level, where they neither sought to restrain economic activity nor boost it. The growth outlook was close to trend.
The future looked set to be one where observers could make a plausible case that leading economies were in what economists call “equilibrium”, or a “steady state” or what Keynes dismissively termed “the long run”. With Japan having had stimulative monetary policy since the early 1990s, this was rare indeed.
Let’s be clear, a steady state or long-run equilibrium is far from a nirvana. Countries can be rich or poor and trend growth rates can be extremely weak. They can also be dissatisfied with the situation.
But the significance is that it would not be clear what would happen next either to interest rates or activity because there would not be a significant imbalance to correct.
That was then, however. Now that we are ending 2024, Keynes has had the last laugh and, just as in his original meaning for the phrase “in the long run we are all dead”, 2025 no longer looks like it will be the steady state it promised.
Instead, central banks are ending this year in a state of some anxiety. Happy New Year!
The Federal Reserve is worried about Trump and inflation
In what was a far from convincing performance, Fed chair Jay Powell laid bare his anxieties in the press conference after the US central bank’s latest meeting earlier this month. “Once again we’ve had a year-end projection for inflation and it’s kind of fallen apart,” he said, explaining the Fed’s new view that there were likely to be fewer rate cuts in 2025 than it previously expected and more inflationary pressure.
Powell was clear that the Fed was closer to neutral interest rates with the cost of borrowing at 4.25 to 4.5 per cent. But that was not job done, he added. “We believe policy is still meaningfully restrictive.” Some members of the Federal Open Market Committee also included likely policies from the incoming Donald Trump administration in their economic projections, also raising interest rates and inflation from the previous forecasts in September.
And, as for the long run, the FOMC is now far from certain about the meaning of “meaningfully restrictive”. As the chart below shows, the vast majority of the committee now thinks the long-run neutral interest rate has risen although members are much less certain what that rate is.
The European Central Bank is worried about a slowdown
The European Central Bank was on a glide path towards neutral interest rates in the autumn. But winter has brought the additional chill of an economic slowdown that might require the ECB to stimulate the economy in 2025.
Instead of maintaining a need for policy to remain “sufficiently restrictive” until inflation was beaten, ECB President Christine Lagarde explained that this language was removed because the central bank thinks the risk to inflation is now “two-sided”.
Lagarde said the central bank saw a neutral rate somewhere between 1.75 and 2.5 per cent — only a touch below the current 3 per cent rate. So, rates are thought to be restrictive in Europe now, but 2025 might bring a need to drop them significantly.
The Bank of England is worried about stagflation
The UK likes to pretend that its economy is different from continental Europe. In one respect it is. While the Eurozone has low growth and low inflation, there is a whiff of stagflation in Britain.
Growth stalled in the three months to October, while underlying inflation has remained too high for comfort. Services inflation has been stuck at an annual rate of 5 per cent since September, with private sector regular pay growing at 5.4 per cent in the year to October.
This data is likely to resolve in 2025 either in an inflationary or contractionary direction, but the current situation is deeply uncomfortable for the Bank of England, as was evident in the big splits on its Monetary Policy Committee at the December meeting.
The Bank of Japan is worried about Trump and the yen
Having started a move into positive territory last spring and ended the zero interest rate environment that applied for almost all of this century, the Bank of Japan suddenly got cold feet about further normalisation. The economic numbers do not prevent further rises, but the central bank is caught between the contradictory concerns about imported inflation due to a weak yen, and fears of a Trump and tariff induced slowdown in 2025.
The virtuous feedback between wages and prices the central bank hoped to see in 2025 is fading — although it is not out of sight yet.
The People’s Bank of China is worried about becoming Japan
In December, the People’s Bank of China loosened its official monetary policy stance for the first time in 14 years to “moderately loose” from “prudent” in a sign that the Chinese authorities are increasingly worried about inflation that has hovered close to zero, lacklustre growth and barely any momentum in consumer activity.
This is not a sign of confidence about growth and inflation in 2025 in the world’s largest economy. Falling Chinese bond market yields are an even better sign that investors believe the economy requires stimulus to maintain adequate growth rates.
The Banco Central do Brasil is worried about repeating the past
Signs of stability are difficult to find in Brazil, with the currency hitting all-time lows in December, significant currency intervention by the BCB, and a rise in interest rates of one percentage point. Inflation is rising only modestly, but the Budget deficit is high and capital flight has been rampant.
The economy will require financial stabilisation to restore confidence before any semblance of the “long run” can be found. This might prove tricky with President Luiz Inácio Lula da Silva saying earlier this month that “the only thing wrong in this country is the interest rate, which is above 12 per cent”.
What I’ve been reading and watching
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Helmut Schlesinger, the ultraorthodox Bundesbank president between 1991 and 1993, has died
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In an economy that has been far from stable in recent years, the Turkish central bank cut rates by 2.5 percentage points on December 26, citing a moderation in inflationary pressure. That brought the short-term rate down to a still hefty 47.5 per cent
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Jay Powell’s control over Fed monetary policy has been a series of flip-flops aggravating volatility around the world in 2024, according to Mohamed El-Erian
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Richard Barwell has a message for central bankers in 2025. Publish estimates of neutral rates, he demands. Barwell quite reasonably argues that these are important in internal assessments of monetary policy, so why do officials so often pretend otherwise?
