(Still) Stumbling Towards Equilibrium

The global economy finds itself navigating treacherous waters. The optimism of late 2024 – that major economies were finally taming inflation without triggering unemployment spikes or unduly impacting growth – has given way to a more cautious reality after two months into Trump's second term.

Central banks have indeed begun their easing cycles, but the pace has been more measured than markets initially anticipated. Monetary authorities remain wary of declaring victory prematurely, particularly as the Trump administration's economic agenda materialises with concrete policy actions rather than mere campaign promises.

Trump’s threats to place substantial tariffs on imports from core trading partners such as Canada and Mexico – which as of this article’s publishing stand at 25% – are likely to result in serious inflationary pressures on products sold in the US (although these have been paused and un-paused on two occasions now). While not yet reaching the "highest-case universal tariff" scenario that economists warned could add 2.2 percentage points to US CPI, even these measures have begun disrupting supply chains and raising input costs. Retaliatory measures from trading partners also signal the potential for a more damaging cycle of economic nationalism.

The much-touted potential federal spending cuts of the meme-coin-derived Department of Government Efficiency (DOGE) are now revealing themselves to be more limited than originally set out – Elon Musk’s Wall of Receipts is facing constant revisions as claimed cuts are being revised due to political pushback, with the firing and re-hiring of staff working on nuclear safety issues being just one of many cases in point. And should multi-trillion-dollar deficit-expanding budgets continue to pass through Congress, cuts of any kind will have little net impact.

Meanwhile, the administration's immigration policies – while yet to fully materialise – are likely to create serious labour distortions in key sectors. Agricultural producers and construction firms’ heavy reliance on migrant labour will result in wage pressures and staffing challenges that threaten to feed into prices for food, homes, and consumer goods.

And what policymakers failed to anticipate just a few short months ago is the dramatic escalation European defence spending will experience in the coming years. The UK’s new long-term commitment to spending 3% of GDP on defence will take more than reallocating the country’s aid budget – and that rate, too, may prove optimistic: the US’ shift away from Europe could necessitate higher spending to make up for expensive, hard-to-replace, capabilities such as satellite-dependent connectivity. Other NATO members will likely go in the same direction. Germany has already voted in favour of reforming the schuldenbremse or “debt brake”, which should give the central government more leeway to expand fiscal activity.

The ECB now faces a particularly delicate balancing act. Rate cuts remain necessary to revive anaemic growth, yet the inflationary potential of increased defence and infrastructure expenditure complicates the path forward. The Federal Reserve faces a different picture – while growth has been relatively strong, tariffs will undoubtedly increase inflationary pressures, perhaps delaying any future rate cuts.

These crosscurrents have intensified the debate around the global neutral rate of interest – R*. Between December 2023 and December 2024, the Federal Reserve’s Open Market Committee, the group responsible for setting the Federal Funds Rate, revised their long-run interest rate expectations upward by 0.5 percentage points. This suggests that the wonks at the helm of America’s monetary policy expect more inflation in the medium to long term. The volatility in these expectations has increased as well, reflecting genuine uncertainty rather than mere technical disagreement. For investors hoping for a return to the post-2008 era of ultra-low rates, the evidence against such an outcome continues to mount. Zero-interest rate environments have occurred only three times in the past 5,000 years – during the Great Depression, after the 2008 crisis, and during Covid. The post-2008 era is a historical anomaly, not the norm.

What remains unclear is whether central banks have fully internalised this reality. The temptation to cut rates in response to any future growth slowdowns remains strong, particularly with political pressure mounting. Yet premature easing could reignite inflationary pressures that have been so painfully suppressed. This would make government borrowing – either to fund ballooning deficits or defence and infrastructure spending – all the harder to achieve. Rate-setters and policymakers alike, then, would do well to acknowledge that the previously established economic compass is spinning – revealing the limitations of our navigational tools.