Central Banks Have Plenty of Room to Cut Interest Rates, Decoupling from Fed May Continue
Policymakers and analysts believe central banks globally have ample space to further reduce interest rates. This "decoupling" from the US Federal Reserve's pause on monetary easing could present challenges for President Donald Trump's planned tariffs and potentially increase borrowing costs for US businesses and households.
Traditionally, the Fed sets the benchmark for global monetary policy. However, in 2025, the US economy is thriving while many other major economies are struggling. This, coupled with uncertainties arising from Trump's policies and trade threats, has restrained the Fed's ability to further cut rates.
Ironically, the global economy's adjustment to the potential trade war is mitigating the intended impact of Trump's tariffs, benefiting foreign companies exporting to the US. Tariffs typically lead to higher domestic inflation, prompting the Fed to maintain higher interest rates. This has strengthened the US dollar against most currencies, making exports to the US more profitable, contrary to the administration's objectives.
Switzerland, for instance, has experienced a surge in exports. "A weaker franc would boost Swiss industry by reducing export costs to the US," noted Karsten Junius, chief economist at J.Safra Sarasin. "This could also offset the potential impact of US tariffs."
The eurozone, a primary target of Trump's rhetoric, could also buffer the impact of tariffs with its currency value having depreciated by 7% since Autumn 2024. "European firms may sacrifice margins to maintain market share," said Piero Cipollone, European Central Bank board member. "Part of this sacrifice could be compensated by the exchange rate, mitigating the overall impact."
While a weak currency typically leads to inflation due to higher import prices, this effect has been offset by subdued growth caused by trade tensions. Policymakers are not overtly concerned about inflation at this stage. The ECB, Bank of England, and Bank of Canada have recently lowered interest rates, despite the Fed's indication of no urgent need for action. The Reserve Bank of India and the Bank of Mexico have also reduced rates.
Tiff Macklem, Canada's central bank chief, noted that the currency impact of interest rate differentials has been modest. The BoE indicated that sterling's decline against the US dollar was minimal.
However, there are limits to this decoupling. Trump, who previously urged the Fed to cut rates, has recently clarified that he refers to the yield on 10-year Treasury notes, which affects mortgage and business lending rates, rather than the central bank's short-term interest rates.
Economic fundamentals are also driving this policy divergence, as the US economy outperforms others, requiring higher interest rates to curb inflation. However, the interest rate gap cannot widen indefinitely.
Policymakers are wary of a potential currency weakness-induced bond market sell-off leading to further currency depreciation and inflation. While this is not considered an immediate threat, policymakers could react if energy prices rise sharply, as oil and gas are primarily traded in US dollars.
Additionally, central banks can influence short-term interest rates, but longer-term borrowing costs are driven by market forces. If US yields rise, other countries' yields are likely to follow, potentially increasing borrowing costs and slowing economic growth.
"European bond yields typically follow US yields," stated GianLuigi Mandruzzato, EFG Bank's senior economist. "Higher US yields would lead to increased borrowing costs in Europe, despite lower short-term rates set by central banks."