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Monetary policy shifts in 2025: What’s next for central banks?

In 2024, we saw a majority of central banks around the world take a gradual easing approach as previously sky-high interest rates were dialled back amid slowing economic activity. With inflation moderating across global markets, we’re poised for a 2025 where central banks have to decide whether to continue rate cuts, hold steady or resume quantitative tightening.

While much of what happens next will likely be determined by what direction markets take in the new year, some analysts believe that the goal of central banks will be more neutralist in nature. “The central banks’ goal for 2025 is to bring interest rates to a level that neither stimulates nor cools the economy, but rather balances it with its potential growth”, says Spanish financial institution, Caixa Bank.

In this quick piece, I take a look at what we may expect from central banks in 2025, especially given the potential deflationary pressures facing Europe and the growing problem that regional conflicts pose to the global economy.

Gradual rate cuts and neutral policy stance

One of the most significant shifts in 2025 is the continuation of gradual interest rate cuts by major central banks. The Federal Reserve (Fed) and the European Central Bank (ECB) are leading this trend, aiming to bring rates down to neutral levels that neither stimulate nor cool the economy excessively. The ECB, for instance, is targeting a deposit rate of around 2%, while the Fed aims for a range of 2.75%-3.25%. This transition from restrictive to neutral policy is designed to support economic stability without triggering inflationary pressures.

Impact of US monetary policy

The Fed’s cautious approach to rate cuts is influenced by persistent inflation and a stronger US dollar, which have significant implications for global financial conditions. The strength of the US dollar can limit the extent of monetary easing in other regions, particularly in emerging markets, where currency depreciation and capital outflows pose additional challenges. As a result, central banks in these regions may adopt a more conservative stance to maintain financial stability.

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monetary_policy_shifts_in_2025_what_s_next_for_central_banks_seref_dogan_erbek_2

Deflationary forces in Europe

Deflationary pressures, especially in Europe, are another critical factor shaping monetary policy in 2025. The ECB and other European central banks are grappling with weak productivity growth and hesitant consumer spending, which contribute to deflationary trends. To counteract these forces, central banks are not only cutting rates but also implementing measures to stimulate economic growth. This includes targeted lending programs and asset purchase schemes aimed at boosting investment and consumption.

Balance sheet reduction

In addition to adjusting interest rates, central banks are also focusing on reducing their balance sheets, which have expanded significantly over the past decade due to quantitative easing programs. The process of balance sheet reduction, or quantitative tightening, is expected to be gradual to avoid market disruptions. Central banks are likely to adopt a measured approach, allowing maturing assets to roll off their balance sheets without reinvestment, thereby reducing the overall size of their holdings over time.

Transatlantic divergence

A notable trend in 2025 is the divergence in economic performance between the US and Europe. The US is expected to experience resilient growth and sticky inflation, driven by robust consumer spending and a tight labor market. In contrast, Europe may struggle with weaker economic growth and deflationary pressures, necessitating more aggressive monetary easing measures. This divergence poses challenges for global monetary policy coordination and could lead to varying financial conditions across regions.

Market volatility and fiscal-monetary tensions

Elevated macroeconomic volatility and country-specific risks are likely to persist in 2025, making diversification in traditional portfolios challenging. Additionally, there will be growing tensions between expansionary fiscal policies and the easing stance of central banks, particularly in the US The disconnect between fiscal and monetary policies could complicate efforts to manage inflation and ensure long-term debt sustainability.

Ultimately, while we’re certain to see more of the top-line pressures that have defined monetary policy in 2024, the new year will also bring additional factors in play such as deflationary pressures and regional economic disparities. I think the gradual reduction of interest rates to neutral levels, coupled with balance sheet reduction and targeted measures to stimulate growth, will be key strategies. However, central banks will need to remain vigilant and adaptable to address the evolving economic challenges and ensure financial stability.

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