Last week the US Federal Reserve (the Fed) did what the market had already priced in – it raised the federal funds rate by 25 basis points, its first hike since 2023, and left the door open for at least one more move before the year is out. Two days later the Bank of Japan (BoJ) followed with its own 25bps increase, taking its policy rate to 1.25%, the second hike of the year, and the highest level Japan has seen since 1995. Earlier in the month, the European Central Bank (ECB) had already lifted its deposit rate by 25 basis points to 2.50%, its second increase this year. Add to this list the central banks of Australia, New Zealand, South Korea, South Africa, Norway and Denmark, all of whom have raised rates in the past three months, and a pattern is hard to miss. The developed world’s four-year experiment with rate cuts has stalled, and in several places, reversed.
To me five things are clear from this trend –
1. Supply-side stickiness is real, and it will not resolve on its own
The inflation we are seeing today is not the demand-driven inflation of 2021-22. It is coming from the supply side – erratic weather hitting agricultural output, and energy prices kept high by the conflicts in West Asia and Ukraine, which have damaged infrastructure, disrupted shipping lanes and pushed up transportation costs. That second-round effect is now visible in user industries such as chemicals, fertilizers and metals, where input costs have simply nowhere to hide. Besides, tariff actions taken through the year in several large economies are adding a second supply shock on top of the energy one, which makes the case for stickiness even stronger than it first appears.
2. The AI deflation story is being asked to do more work than it can
It is tempting to lean on artificial intelligence as the great disinflationary force that offsets everything else. The evidence so far is much narrower than that – lower prices in IT services, and wage pressure easing for some categories of skilled labour. AI is not a one-sided deflationary force. The capital being poured into data centers, chips and the power grid to run all of this is itself adding to demand in construction, electricity and industrial metals – the same industries already feeling the energy squeeze. Netting the two effects out, I would not count on AI to meaningfully soften the inflation picture in the next year or two. If anything, the investment boom around it is currently a mild net contributor to price pressure, not a relief valve.
3. “Higher for longer” is now the working assumption, not a tail risk
Four major central banks hiking within weeks of each other, ten-year US treasury yields pushing back above 5%, and rate-setters at every one of these institutions choosing to keep their options open rather than signal a pause – this is about as clear a signal as markets get. The cost of the capital regime the world built its valuations on through 2020-24 is not coming back in a hurry.
4. Emerging markets face a harder version of this problem, but the response is not automatic
The pressure on economies like India to defend their currencies and retain capital is genuine. But it does not translate mechanically into higher policy rates. The RBI’s own conduct this year is the evidence – it has held the repo rate at 5.25% through a period when the rupee slid to record lows near 97 to the dollar, choosing instead to lean on FCNR(B) inflows, external commercial borrowing windows and direct market intervention rather than touch the policy rate. That is a rational choice: a defensive hike raises borrowing costs across the whole economy at a time when growth is already being marked down. The emerging market central banks are being forced to spend more of their other tools – reserves, swap lines, capital account measures – to buy themselves room before they are cornered into raising rates outright.
5. The gold trade
Gold touched an all-time high near $5,600 an ounce in January this year, driven by – (a) central banks diversifying out of dollar assets after the freezing of Russian reserves in 2022, and (b) a market pricing in lower yields ahead. Since then, as the rate-cutting narrative has been replaced by an actual hiking cycle, gold has already given back a meaningful part of that rally, trading closer to $4,400 in recent weeks. The “higher for longer” leg of the gold trade is not something to watch for next year – it is unwinding in real time, even as the “diversify away from the dollar” leg continues to bring in steady central bank demand and keeps a floor under prices well above where they traded before 2022.
Will share my thoughts on what it means for investment strategy later this week.