Global central bank outlook: Divergent paths on rates

Divergence figures to be the primary theme in global central banking during the final six months of the year as policymakers around the world adjust to higher American tariffs.

In the United States, the Federal Reserve will have to determine whether tariffs will be a one-time price shock or turn into sustained inflation. But in Europe and elsewhere, central bankers will be dealing with the risks of slowing growth and disinflation caused by the tariffs, which will only add to the pressure to cut rates.

We expect the European Central Bank and the Bank of England to adopt modest cuts, while the Federal Reserve will hold rates steady for now. 

Federal Reserve: Modestly restrictive with room to cut

The Federal Reserve has rate cuts on hold as it determines the impact of tariffs on both the U.S. domestic and global economies.

Our own model of the Fed’s reaction function implies that its policy is modestly restrictive, with room to reduce its policy rate should Fed officials be convinced that tariffs are transitory. In determining the Fed’s reaction function, we use a modified version of the Taylor Rule, which is an equation that factors in the unemployment rate and inflation to set the appropriate federal funds rate.

If the labor market softens, though, or if inflation increases to 3%—well above the Fed’s 2% target—then two rate cuts are possible, one in September and one in December. Our current forecast is for one rate cut in December.

European Central Bank: Mitigating tariff shock

The European Central Bank reduced borrowing costs by 25 basis points in June, bringing its policy rate to 2% to get out in front of U.S. higher tariffs. Still, inflation in the European Union stands at 1.9%, below the ECB’s 2% target, and the central bank stands well positioned to declare victory on a return of price stability.

The central bank should feel comfortable reducing its policy rate by another 25 basis points in the second half of the year to cushion the blow from U.S. tariffs.

Bank of England: Gradual and cautious

As economic headwinds gather amid sluggish growth and cracks in the labor market, the Bank of England’s Monetary Policy Committee has room to reduce interest rates further to support growth and employment.

But with inflation well above the Bank of England’s 2% target and likely to rise over the summer, and with wage increases still significantly above the 3% level that is consistent with 2% inflation, the MPC is constrained. We expect one 25-basis-point rate cut in the third quarter and another in the fourth as the central bank moves cautiously. 

Bank of Japan: Threading the needle

The Bank of Japan has one of the more difficult paths to tread. Given a renewed focus among global investors on debt and deficit dynamics, the Bank of Japan’s quantitative tightening is of paramount interest during the final six months of the year.

In June, the central bank cut its pace of quantitative tightening in half to ensure market stability, but that does not signal an end to its asset purchases. We expect a 25-basis-point hike at its July meeting.

People’s Bank of China: Waiting on direction

The People’s Bank of China simultaneously reduced its policy rate by 10 basis points, to 1.4%, in May while cutting its reserve requirement rate by 50 basis points.

As economic headwinds grow, we expect China’s central bank to cut its policy rate by another 20 basis points in the second half of the year in an attempt  to cushion the blow from U.S. tariffs and accommodate its domestic debt and deleveraging crisis.

For now, though, the PBOC is on hold as it awaits the outcome of U.S.-Chinese trade negotiations and the August Politburo meeting that traditionally provides direction on economic policy.

Bank of Canada: Two rate cuts

The Canadian economy faces a bumpy adjustment to the American tariff shock. The probability of a recession in Canada over the next 12 months is more or less a coin flip, at 55%.

Trade uncertainty hurts business and consumer sentiment, hiring and consumer spending. The Canadian economy likely contracted in the second quarter and will continue to do so in the third quarter before expanding in the fourth quarter, with growth this year slowing to 1%.

We expect two more rate cuts this year, which would bring the policy rate to 2.25%, at the bottom of the neutral range. Should a sharp downturn occur, rate cuts will come faster.

Reserve Bank of Australia: Return to neutral

The Reserve Bank of Australia is beginning to chart a different course from last year—one that reflects growing confidence in the disinflation momentum at home.

A likely rate cut in July, followed by another in August, signals that the RBA sees a return to neutral policy settings as not only manageable but also necessary to support a slowing economy.

Recent data—including softer-than-expected growth in gross domestic product, subdued business conditions, tepid consumer sentiment and a benign inflation report for May—suggest inflationary pressures are fading more quickly in Australia than previously anticipated.

Unlike its global peers, which continue to prioritize price stability, the RBA appears more concerned about the risks of overtightening, particularly as private sector demand struggles to pick up the slack from waning public stimulus. In addition, concerns about a slowdown in China weigh on policymakers' minds.

This divergence underscores Australia’s unique economic position: one where disinflation and a fragile recovery demand a shift from holding the line to carefully easing off the brakes.

We expect the cash rate to end the year at 3.35%. But amid global uncertainty, there is a clear downside risk that the RBA could deliver another cut in November, potentially bringing the year-end rate to 3.1%.

Reserve Bank of India: Cutting rates

The Reserve Bank of India made clear at its June meeting that it has moved toward accommodation as the economy slows. While the central bank may hold rates steady in August, we expect another 50-basis-point cut, which would reduce the repo rate to 5% following the June cut of 50 basis points.

In addition, the RBI’s announcement that it would reduce the cash reserve ratio by 100 basis points by the end of the year, which should result in a liquidity injection of 2.5 trillion rupees, should bolster the economy just as global headwinds are growing and inflation expectations are moderating.

The takeaway

As the global economies grapple with a changing landscape on trade, the major central banks will take different approaches to the challenge. We expect the European Central Bank and the Bank of England to adopt modest cuts, while the Federal Reserve will remain on hold for now.

Thomas Pugh of RSM UK and Devika Shivadekar of RSM Australia also contributed to this article.