Donald Trump’s threatened trade war is driving a wider wedge between the world’s biggest central banks, as the US Federal Reserve holds off rate cuts even as growth concerns hang heavily over other economies.
On Thursday, the Bank of England became the latest central bank to cut interest rates this year, lowering bank rate by a quarter point to 4.5 per cent.
The Fed, however, is taking a different approach. It held borrowing costs last week, with chair Jay Powell indicating interest rates will remain on hold as the strong US economy enables policymakers to wait and see how tariffs and Trump’s other policies impact inflation.
The European Central Bank and Bank of Canada have already cut borrowing costs this year and have left the door open to further reductions amid concerns that a trade war with the US could hit growth.
“A few years ago, central banks were quite reluctant to move away from the Fed. The threat of tariffs and the general uncertainty has shifted that,” said Dario Perkins, economist at TS Lombard. “It’s a much clearer policy decoupling now.”
Markets have taken note of the trend, pricing in more cuts outside of the US since the election as investors anticipate central banks will try to soften the blow from tariffs. They expect another three to four quarter-point rate cuts from the ECB this year and the same from the Bank of England, including Thursday’s cut.
“Brinkmanship aside, the differential across countries could be really big,” said Robert Tipp, head of global bonds at asset manager PGIM. “The US is really in a much better position in a trade war, given that it is primarily the world’s customer . . . that is why US markets are going to be less impacted. For other countries, stronger, more diversified economies are going to have better outcomes.”
With inflation set to hover above the Fed’s 2 per cent target throughout 2025, many economists — including some members of the rate-setting Federal Open Market Committee — think Trump’s tariffs could hit prices more than during his first term — especially in the hot US economy.
“The Fed’s position to keep interest rates on hold is completely understandable,” said John Llewellyn, a partner at Independent Economics, a consultancy. “Other central banks are more worried — and probably rightly — about the effects of uncertainty on demand and activity than they are about inflation.”
Llewellyn added that “everything President Trump says he’s going to do is inflationary — certainly tariffs, certainly tax cuts”.
Trump delayed his plans to impose 25 per cent tariffs on Canada and Mexico by 30 days and has threatened to impose charges on EU goods. This week he went ahead with a 10 per cent levy on China.
China could respond by weakening its currency and selling its goods at cheaper prices to maintain global market share — in effect, exporting disinflation to the rest of the world, bar the US.
Tariffs usually cause a one-off inflationary shock on the economy where they are imposed, but can lead price rises to settle at rates higher than central bankers might like.
Whether that happens depends on how easily businesses find substitute products, the impact of a stronger currency and business and consumer inflation expectations.
Powell said last week that officials were “just going to have to wait and see” how those effects would play out before responding.
Fed vice-chair Philip Jefferson said on Tuesday that he was “in no rush” to cut either.
Austan Goolsbee, president of the Chicago Fed and a voting member of the rate-setting Federal Open Market Committee, said on Wednesday that central banks’ tendency in the past to downplay the inflationary consequences of supply shocks such as the imposition of tariffs was “dangerous”.
While holding rates would put US rate-setters on a collision course with a president who has made clear he wants borrowing costs to fall “a lot”, most economists think Trump’s policies leave the Fed with little choice.
Between them, Mexico, Canada and China alone account for around two-fifths of total US imports — leading to likely price rises that could trigger bigger wage demands and higher costs in other parts of the economy.
“When you are running the economy fairly hot anyway, the risk of inflation expectations getting unanchored is significantly worse than elsewhere,” said Holger Schmieding, economist at Berenberg Bank.
The situation is very different in the Eurozone, where official data published last week showed that the economy registered no growth in the final three months of 2024. The central bank last week lowered borrowing costs by a quarter point to take rates to 2.75 per cent.
Analysts at Citi said that even if the EU imposed a 10 per cent retaliatory tariff on US non-energy imports, it would have a very small 0.05 percentage point upward impact on core consumer prices inflation.
“In Europe they are much more concerned about the growth impact than the potential inflation impact,” said George Buckley, an economist at Nomura, pointing out that Eurozone exports to the US are a larger share of its GDP than imports from the country.
The Bank of Canada last week cut interest rates to 3 per cent as it warned a trade conflict with the US would badly hurt economic activity while also pushing up prices. Governor Tiff Macklem said the move was made to get ahead of the impact of tariffs should Trump impose a 25 per cent levy on Canadian exports.
Canada sells about 77 per cent of its merchandise exports to the US, according to official statistics.
While Trump has suggested that the UK, which holds a goods deficit with the US, might yet escape punitive tariffs, the BoE pointed to increasing global economic uncertainty as part of the background to today’s decision.
Its official rate is currently higher than the Fed’s as the BoE wrestles with the prospect of a near-term pick-up in inflation. But traders are betting on steeper BoE reductions this year as the UK economy weakens.
“The Bank of England will hope the UK will avoid direct tariffs,” said Krishna Guha of Evercore ISI. “But the UK as an open economy will be hit by second-round effects of weaker global trade.”
Additional reporting by Olaf Storbeck in Frankfurt
