[Market Column] Why We Expect Two or More U.S. Interest Rate Cuts This Year

[Market Column] Why We Expect Two or More U.S. Interest Rate Cuts in 2025

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US Inflation Burden VS Positive Factors

[Market Column] Why We Expect Two or More U.S. Interest Rate Cuts This Year

As the US Consumer Price Index (CPI) exceeded expectations in January, the US 10-year Treasury yield surged to 4.6%, up about 10bp from the previous day. Supercore services (core service prices excluding housing costs) rose 0.76% month-on-month, accelerating the pace of increase compared to the previous month (December: +0.21% MoM). Due to concerns about reacceleration of inflation, the probability that the Fed will cut rates at least once by the June FOMC has dropped to slightly over 50% based on the current CME FedWatch.

The recent rise in US inflation expectations is a factor that heightens caution. In a February survey by the University of Michigan, US consumers’ short-term (one year later) inflation expectations rose sharply to 4.3%, compared to 3.3% in January. If inflation expectations continue to rise, it will limit the overall wage and supercore service inflation stability. It is believed that this rise in inflation expectations is partly due to concerns about the Trump administration’s tariff imposition.

Although inflationary pressures persist, there are also positive factors. (1) Other accommodation and airfare items, which recorded high growth rates in the January CPI, are among the items with high monthly volatility among service prices; (2) The sharp increase in auto insurance premiums is considered an estimated price and is not included in the market-based PCE inflation presented by the Fed; and (3) the rigid OER item among housing costs has recently slowed down to the early +0.3% monthly pace, supporting expectations of continued disinflation.

According to the U.S. Bureau of Economic Analysis (BEA), which releases the PCE, the index of market-based prices based on prices actually transacted in the market, excluding food and energy, slowed to 2.4% year-on-year in December. Items not included in the market-based price index include used car sales margins, auto insurance premiums, life insurance premiums, and portfolio management fees. These are considered estimated prices rather than prices paid through actual transactions, and are therefore non-market-based prices.

Here are the main items of market service prices excluding food and energy according to the BEA classification criteria (Table 1). Most service prices, excluding leisure, finance, accounting, clothing, and childcare services among market-based prices, are slowing down similar to past inflation stabilization periods. Among the healthcare items with high weights in PCE inflation, outpatient treatment and hospital and nursing home services are market prices. The two items are recording a +0.1 to +0.2% increase rate compared to the previous month, recording a similar increase rate to before the pandemic.

Market-based service price stability and slowing housing costs are the reasons for expecting the Fed to cut interest rates at least twice this year. In the short term, considering the Fed and the market’s heightened inflationary concerns, the US 10-year Treasury yield is expected to move sideways around 4.5%. In the meantime, it is necessary to additionally check the changes in tariff policy, the results of trade negotiations, expected inflation trends, and the stability of service price items whose increases temporarily expanded in January.

 Ample inventory will mitigate some of the inflationary impact of tariffs

In U.S. personal consumption expenditure, consumption of goods accounts for about 30% (as of 2024). The dependence on imports in expenditure of goods is about 47%. Products imported from Mexico and Canada account for 13.2% of total consumption expenditure of goods, and those from China account for 6.3%. If a 25% tariff is imposed on imported goods from Mexico and Canada without exception, there is a risk that the upward pressure on inflation will be greater than when tariffs against China were imposed on some items such as steel in 2018.

If U.S. importers secure a large amount of inventory and diversify their supply chains, the cost pressure due to tariff increases may be partially alleviated. Recently, the inventory growth rate of manufacturers, especially manufacturing companies, has been increasing. Empirically, when the growth rate of new order amounts begins to slow down, the inventory growth rate also tends to slow down. In 2018, the new order amount turned to a downward trend, but inventory continued to increase to avoid the risk of additional tariff increases. This led to a slowdown in the manufacturing industry and a decline in the price index.

President Trump has announced that he will expand the scope of tariffs to the EU in addition to Mexico, Canada, and China. With inflation still unstable, the uncertainty of tariffs is expected to continue, and companies are expected to continue to work to secure inventory. The current inventory-to-sales ratio of U.S. companies is about 1.37 times, which is lower than mid-2018, but slightly higher than the average inventory ratio (1.34 times) from 2000 to the present. 

Considering the recent ISM manufacturing index, the current manufacturing slowdown is in progress and the growth rate of new industrial production orders by companies is stagnant. Considering this, it is judged that there is no significant shortage of inventory by importers in general. In a situation where sufficient inventory is secured, companies can absorb some of the tariff increase without passing it on to consumers.

Although tariff increases may inevitably lead to price increases for some items, we believe that inflationary pressure is unlikely to continue. The possibility of a decrease in consumer demand due to high inflation burden and an increase in inventory are expected to contribute to disinflation.

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