After a week of intense policy meetings, the Federal Reserve, European Central Bank, and Bank of Japan have taken divergent paths in tackling economic challenges. Although global growth fears have eased, persistent uncertainty continues to influence their monetary policy decisions.
Let’s start with the most important one; the US Federal Reserve cut its policy rate by 25 basis points to a range of 4% to 4.25%.
While the decision was expected, it doesn’t mean it was straightforward. Two committee members dissented, which is rare enough, but they dissented in different directions. Stephen Miran, an economic adviser to US President Donald Trump and temporary member of the Fed Board of Governors wanted a larger rate reduction. The president of the Federal Reserve Bank of Kansas City, Jeff Schmid, voted for no change.
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Apart from internal disagreement, the Fed faces the additional problem of a lack of official data on the state of the US economy as the government shutdown drags on.
The consumer price index for September was released because it has important practical implications beyond economic analysis: social security benefits are indexed to the CPI, as are inflation-protected bonds. However, it is not a given that October CPI data will be released if the shutdown continues, and there is still no sign of a breakthrough in Washington.
Consumer inflation rose to 3% in September. While economists expected a slightly higher number, the fact remains that inflation is rising away from the 2% target, and it is highly unusual for the Fed to be cutting rates when inflation is increasing. Then again, these are unusual times. The silver lining is an ongoing steady decline in rental inflation, which partly, due to the way it is measured, has long been elevated and slow to decline. Non-housing service inflation did not rise further but remains sticky around 4%, however.
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Even with an abundance of data, the Fed’s decisions would still not be simple. It has a dual mandate of stable prices and low unemployment, and the scorecard on these two goals is mixed.
Tariffs are placing some upward pressure on inflation, even though the impact has been muted to date. Employment growth has been cooling, but given the sharp drop in immigration, the US economy needs fewer new jobs to maintain a low unemployment rate.
There are no indications of a widespread increase in retrenchments, a few high-profile announcements notwithstanding. The housing market remains in the doldrums, but other sectors are holding up well, as suggested by privately produced purchasing managers’ indices.
Adding to this mixed picture is of course the constantly evolving trade-policy landscape. Trump and his Chinese counterpart, Xi Jinping, agreed to a one-year trade truce last week. It will keep open the flow of rare earths from China, while the US will cut tariffs on China somewhat. This does not resolve any of the underlying tensions but will relieve some of the inflationary pressures Powell and company are worried about and, more importantly, reduce downside growth risks.
Far from foregone
At the post-meeting press conference, Fed chair Jerome Powell made it clear that a December rate cut was far from a “foregone conclusion”. Having lowered interest rates to a more accommodative level, it seems possible that the Fed can pause a bit and assess the situation, though it would be wishful thinking that there will be clarity any time soon. This is at odds with market expectations for ongoing rate cuts.
For the technically minded, it should also be noted that the Fed decided to stop shrinking its balance sheet. Whereas in the past, decisions to expand or contract its balance sheet was a direct policy intervention to influence long-term interest rates, it is increasingly about ensuring that banks have enough of a special form of cash known as reserves so that the financial system can function properly.
One rate, many countries
Across the Atlantic, the European Central Bank (ECB) left rates unchanged at 2% in a widely expected decision. Its core difficulty is not that its twin mandates are pushing in different directions, as in the case of the Fed. The ECB has a single objective: to keep inflation at 2%. However, its problem remains that it must set policy for 19 different countries, each usually at a slightly different point in its business cycle.
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Overall economic growth in the eurozone has been decent, expanding by 1.3% in the four quarters to end September. However, among the four biggest Eurozone members, France grew by 0.9%, while Italy has been crawling along at only 0.3%.
Germany also grew 0.3%, barely recovering from the 2022 to 2023 energy crisis-induced recession. In contrast, Spain has been booming, posting almost 3% growth. With a stronger economy, Spain has firmer inflation of 3.1% in October, while Germany’s inflation rate was 2.3% and France at 1%. Overall, eurozone inflation was 2.1% in October.
The ECB started its cutting cycle well before the Fed, and reduced rates by 200 basis points between May 2024 and June 2025. It has been on pause for the last three meetings. With inflation near target and the Eurozone economy on a sounder footing, it can be patient in assessing how the economic and inflation outlook responds to its earlier rate cuts.
The outlier
Alone among major central banks, the Bank of Japan (BoJ) has been gradually increasing its policy interest rates after three decades of low and even negative borrowing costs.
Its problem in the 21st century has been that inflation is too low. Therefore, it was uniquely relieved when the global post-Covid inflation surge also pushed Japanese inflation upwards. However, since this was mostly due to food and energy prices and a weak yen, there are question marks whether it will be sustained.
For firms to continue to increase prices by around 2% a year, there will have to be the kind of wage growth that gives consumers enough purchasing power to absorb such price increases. Therefore, the BoJ has proceeded very slowly, with only three small increases in the past 18 months, taking its policy rate from -0.1% to 0.5%.
There was no change at last week’s meeting, which came soon after the election of Sanei Takaichi, Japan’s first female prime minister. Takaichi is a proponent of "Abenomics" (named after her mentor, the late Shinzo Abe), a policy package of structural reform, fiscal spending and very loose monetary policy.
She has previously stated that the BoJ should align itself with the government’s economic policy and once called its rate hikes "stupid". As prime minister, she is likely to be more tactful and give the BoJ space to do what it needs to, but the market is scaling back expectations of future rate increases, weakening the yen.
Nonetheless, closer co-operation between monetary and fiscal policymakers could be something that spills over from Japan to the rest of the developed world. It would not be the first time that Japan is a leading indicator, as its long battle against deflation made it a bit of a policy laboratory.
Fiscal dominance, as academics call it when a government’s spending, taxation and borrowing needs dictate or constrain what central banks can do, could be making a comeback. In the years following the 2008 global financial crisis, central banks were “the only game in town” to borrow the title of a prominent book on the subject.
Fiscal policy was in retreat due to an unnecessary (at the time) obsession with government debt, and central banks stepped into this vacuum. The Fed embarked on several rounds of quantitative easing, and it was the ECB that ultimately ended the eurozone debt crisis with President Mario Draghi’s “whatever it takes” commitment.
When the Covid crisis hit, central banks again stepped in forcefully, but this time there was fiscal stimulus too. By 2025, most of the talk has been about fiscal matters, such as US tax cuts and German defence spending.
Central banks remain important, but this importance could be fading in two important respects. Firstly, central banks only control short-term interest rates, but what matters for the economy is broader financial conditions, including market-based interest rates.
One prominent example was how the Fed’s hiking cycle in 2022 was blunted by the fact that most American homeowners had fixed their mortgage rates at very low levels and were largely unaffected. More recently, we saw government bond yields increase across several developed countries even as central banks lowered short-term rates.
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Secondly, central banks have been criticised for overstepping their mandates. Trump’s Treasury secretary, Scott Bessent, has made this claim, but he is far from the first.
Recent years have seen central banks involved in discussions around inequality and climate change, for instance, which some argue is beyond the scope of monetary policy. Moreover, there will always be tension between unelected technocrats in the central bank making important decisions, and democratic accountability.
This points to a narrower focus from the Fed when Powell’s successor is appointed early next year. The longer-term question of how the Fed will help the Treasury manage its debt load remains to be answered but comes with risks.
The reason why central banks were given independence to set policy without political interference is because elected officials will almost always prefer lower interest rates and a hot economy. An independent central bank can take a view beyond the next election cycle to keep inflation in check longer-term.
But we should also acknowledge that the role of central banks has continuously evolved over time and will continue to do so. The oldest central banks such as the Bank of England simply existed to help the government borrow money. By the early 20th century, crisis fighting became more important and the Fed was created in the wake of the Panic of 1907.
The early 1950s were an era of financial repression, where central banks kept rates low to help governments reduce debt incurred to fight the war. The global wave of central bank independence around the 1980s and 1990s was largely in response to the inflation crisis of the 1970s, while the unorthodox policies of the 2010s were in response to the 2008 crisis.
The next crisis might well be related to government debt, which could require a different reaction function and toolkit.
For now, markets seem relaxed about all this. Longer-term inflation expectations embedded in bond markets (the difference between nominal and inflation-protected yields) have moved sideways over the past three years as chart 5 shows.
Though the implied inflation rate is higher than before Covid, it is not rising, suggesting that the market is not pricing in a strategy of inflating away government debt over the next decade. At least not today. What actually happens 10 years from now is unknowable.
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For now, we can summarise the picture as follows: outside of Japan, interest rates across the world have declined notably from the 2022/23 peaks. This is supportive for economic activity and has been an important offset to recent tariff-related headwinds. Lower rates are also typically good for equity valuations.
If the rate-cutting cycle is now near its end, it will disappoint some investors, but it will matter why. A continuation of the cycle can be for good or bad reasons. Rate cuts due to economic weakness and rising unemployment would not be a good sign, but if the cuts are due to subdued inflation, markets will cheer.
Similarly, if central banks in major economies stop cutting rates because economic growth is holding up, that is not a bad thing. However, if they stop out of concern of a revival of inflation, particularly in the US, it would be a different matter altogether.
