If the Federal Reserve lowers interest rates this year, such a rare combination of "inflation and interest rate cuts" last occurred in the second half of 2007

If the Federal Reserve cuts interest rates this year, the market will witness a rare scenario of declining rates coexisting with rising inflation.

According to news from the Chase Trading Desk, a global research team led by Bank of America analyst Howard Du stated in their latest report that the market has currently priced in nearly a 100% probability of a 25 basis point rate cut by the Federal Reserve in September, with cumulative rate cut expectations for the remainder of the year reaching at least two times. If the Federal Reserve restarts the rate cut cycle, any cuts this year may occur against the backdrop of rising year-on-year inflation.

The report noted that even if the month-on-month CPI increases only moderately by 0.1%, the year-on-year CPI is expected to rebound to around 2.9% by the end of the year, significantly higher than the 2.3%-2.4% level seen in the first half of the year.

Bank of America pointed out that this combination of "rising inflation and declining rates" is quite rare. Since 1973, the probability of the Federal Reserve cutting rates while inflation is rising has been only 16%.

Historical data shows that this scenario is typically a bearish signal for the dollar, which has averaged a depreciation of 1.6% during the same period, starting to depreciate before the rate cut and declining by 0.3% one month and three months after the cut, only rebounding by 1.7% six months later.

The market bets on rate cuts, but inflation may rise

Although Bank of America's own baseline scenario does not predict a rate cut until 2025, market sentiment has already shifted.

Following the soft non-farm payroll data in July and the downward revision of previous months' data, the pricing probability for a September rate cut in the interest rate market has rapidly climbed.

At the same time, the inflation outlook carries upward risks.

Bank of America's calculations show that based on the base effect, even if the month-on-month CPI increase remains at a moderate level of 0.1% for the remainder of the year, the year-on-year CPI is still expected to rebound to around 2.9% by the end of 2025, significantly bouncing back from the 2.3%-2.4% level seen in the first half of the year.

If we analyze using the core PCE price index preferred by the Federal Reserve, the upward trend in year-on-year indicators may even appear earlier. Additionally, the already implemented "equivalent tariff" policy has introduced upward risks to inflation from the supply side in the coming months.

The historical rarity of the Federal Reserve's policy combination

The Federal Reserve cutting rates in the context of rising inflation is the least common scenario among four policy combinations.

According to Bank of America analysis, among the four inflation and interest rate policy combinations since 1973, "rising inflation and rising rates" accounts for 33%, "declining inflation and declining rates" for 32%, "declining inflation and rising rates" for 19%, while "rising inflation and declining rates" accounts for only 16% The second half of 2007 to the first half of 2008 was the last period when this policy combination appeared. At that time, rising global energy and food prices pushed up overall inflation and had a partial spillover effect on core inflation, but the Federal Reserve chose to cut interest rates based on early signs of weakness in the real estate and labor markets.

The dollar may record its worst performance since 1999

When central banks cut interest rates amid rising inflation, it lowers the inflation-adjusted real policy interest rate, thereby weakening the attractiveness of the domestic currency.

According to Bank of America’s backtesting of historical data, in the scenario of "rising inflation and falling interest rates," the dollar depreciated the most during the same period, with an average return of -1.6% over six months.

This negative impact has a certain degree of inertia. Data shows that the dollar's weakening trend often continues in the 1 to 3 months following the Federal Reserve's first rate cut. However, over a six-month time frame, the dollar may rebound. This is usually because the subsequent cooling of inflation exceeds the extent of further rate cuts, thereby slightly pushing up real interest rates.

The report also analyzes that so far in 2025, the correlation between the dollar's performance and history is highest compared to 2007, and this year, the dollar is expected to record its largest annual decline since 1999.

In terms of specific currency pairs, the dollar/yen (USDJPY), which is highly sensitive to U.S. interest rates, tends to experience the largest declines in this scenario