More Neutral Policy Settings
There has been an interesting mix of cyclical and structural news over the past week. The latter came through the actual volatility of US trade policy and the official assumptions of the BoE and ECB unveiling updates to neutral rate estimates. Meanwhile, the cyclical news wasn’t so much from the unsurprising rate cuts in the UK and Mexico. It instead reflected guidance, surprisingly strong Euro area inflation and US payroll data revealing a surprise fall in the unemployment rate and a 0.5% m-o-m surge in average hourly earnings.
Although Euro area inflation only exceeded the latest expectations by 0.1pp, it is 0.3pp above the previous consensus—only food prices marginally undershot expectations. Services inflation was stickiest at 3.9%, still close to its late-2023 pace as pressures persist. Tight labour markets still suggest that monetary conditions are relatively loose. Easing is no solution to structural problems, and market pricing is inconsistent with the cyclical story (see EA Inflation Protrudes Pressure In 2025).
The BoE’s unsurprising 25bp rate cut came with a shockingly dovish vote split as the former hawkish dissenter (Catherine Mann) was revealed as an activist in backing an immediate 50bp reduction. Bank inflation forecast revisions are trending up, now touching the target with only one or two more cuts as the MPC appears more cautiously concerned about persistence. We maintain our call for the BoE to hold rates in March before delivering a final 25bp cut in May, assuming conditions end the Fed’s cycle in March and ECB in June (see BoE Activist Joins 50bp Dissent).
Both the BoE and ECB updated their neutral rate estimates this week while being at pains to emphasise the uncertainty. The BoE’s estimates have increased by 25-75bp over the past year from 2-3%, which still seems too low to us (see?Why Neutral Rates Are High, 27 February 2024). ECB staff estimates have increased by less but the 1.7-3% range acknowledges the possibility that the 2.75% deposit rate is already no longer a tight setting. That doesn’t mean they’ll immediately stop easing policy, but it opens the door to more cautious gradualism after the ECB’s March cut.
Policymakers naturally can’t rely on inevitably uncertain neutral rate estimates when calibrating the current policy rate. They must instead look at evidence of the prevailing tightness squeezing or stimulating the labour market, including as it appears in credit conditions. US trade policy is also highly uncertain, but at least the prevailing tariff schedule is visible, even if it is prone to abrupt change and reversals.
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Canada and Mexico’s experience aptly demonstrated the volatility as their threatened tariffs were paused after making some commitments to act on border security and drugs. Even though Donald Trump has held fire for now in the case of Canada and Mexico, the threat of tariffs on America’s allies suggests that the tax war he launched, almost unnoticed, on 20 January against Europe could get even bloodier than battles over trade-in-goods (see US vs EU Part 2: Tax War). Meanwhile, the 10% tariffs on China went ahead and were met by some retaliation, including on rare earth metal exports, which is a supply chain issue worth watching.
The UK remains outside of Trump’s focus, but its trade policy contains options that would help the UK economy’s potential regardless. Rejoining PEM would better integrate the UK into regional supply chains by easing rules of origin and tariffs for manufacturers reliant on EFTA and Mediterranean suppliers. PEM rules have become more flexible but could impose stricter conditions on EVs and batteries before 2027, creating short-term risks for UK automotive production. Although it would not transform UK-EU trade, simplifying compliance, lowering costs, and improving market access make it a pragmatic step in reducing post-Brexit frictions (see Brexit Redux: Rejoining PEM).