Risks to our 2025 outlook

Fed is walking a fine line

The coming year is unlikely to be easy for the Federal Reserve. Inflation is likely to remain above its target of 2% in the coming year. Capacity utilization in the economy remains high, which suggests that wages will continue to rise quite strongly, which companies will probably largely pass on to their customers. Added to this is the emerging economic policy of the new Trump administration. The planned significantly higher tariffs and more expansionary fiscal policy are likely to significantly increase inflationary pressure.

The Fed will be walking a fine line when reacting to the rise in inflation. If it raises interest rates significantly, this would place a heavy burden on the financial markets. After all, the prospect of lower interest rates has at least contributed to the very positive development of the stock markets in recent months, and no interest rate hike is currently priced in on the futures markets. On the other hand, the Fed standing still despite rising inflation could also cause unrest on the financial markets and cause inflation expectations to rise, especially if there is a suspicion that the Fed would give in to political pressure. This would probably leave deep marks on the bond market in particular.

We assume that the Fed will successfully walk this tightrope. One argument against interest rate hikes (which are certainly appropriate in the longer term) is that this would put the Fed in open conflict with the government. The expected attacks from the White House would probably make some investors doubt that the Fed could maintain its independence in the long term. We therefore assume that it will not respond to higher inflation with interest rate hikes for the time being.

However, it is likely to stop its interest rate cuts at a key interest rate of 4% and point out that interest rates are still at a rather restrictive level. Investors are likely to take this on board and not revise their long-term inflation expectations upwards. After all, the Fed enjoys great confidence on the markets. As a result, investors' inflation expectations remained well anchored even if the central bank initially reacted hesitantly to the inflation shock in 2022.

Recession in the eurozone?

While the US economy continues to grow quite strongly and is thus conjuring up inflationary risks, there is still no sign of the generally expected upturn in the eurozone. On the contrary, the Composite PMI fell again in November and is now at a level at which the eurozone economy was mostly in recession in previous cycles. Therefore, it cannot be ruled out that the eurozone economy will slide into recession before it picks up. After all, there are plenty of potential negative factors: weak demand from China, the threat of US tariffs on imports from Europe and the urgent need to consolidate public finances in some eurozone countries such as France and Italy.

However, the biggest negative factor of the past two years is likely to become less and less important: the ECB's massive rate hikes between summer 2022 and autumn 2023. By now, the economy should have largely become accustomed to the fact that borrowed funds have a significantly higher price again. Projects that are no longer profitable with higher interest rates are likely to have been largely discontinued, meaning that this adjustment process will no longer slow down growth. Instead, the rate cuts made by the ECB and many other central banks since the summer are likely to have an increasingly positive impact over the course of the coming year and stimulate an economic recovery, albeit a weak one (forecast for the eurozone in 2025: 0.9%).

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