Central Bank Policy Divergence: How the Fed's “Look Through” Approach Reshapes Global Capital Flows and Asset Valuations

In 2025, the Federal Reserve's “look through” strategy—prioritizing long-term inflation expectations over short-term volatility—is redefining global capital flows and asset valuations. This approach, which dismisses transitory inflationary shocks like tariff-driven price spikes, contrasts sharply with the European Central Bank (ECB) and Bank of England (BoE), which have adopted more aggressive rate-cutting paths. The resulting policy divergence is creating a fragmented global financial landscape, with profound implications for equities, commodities, and emerging markets.

The Fed's “Look Through” Strategy: A Calculated Ignorance of Short-Term Noise

The Fed's June 2025 decision to keep rates unchanged at 4.25%-4.50% reflects its belief that inflationary shocks from tariffs and supply chain disruptions will fade without requiring immediate intervention. Chair Jerome Powell emphasized that the central bank is “not letting these one-time price increases distort the broader economic picture,” a stance rooted in the idea that inflation expectations remain anchored. This approach assumes that businesses will absorb some cost increases from tariffs, delaying their full impact on consumer prices.

However, this strategy carries risks. If inflation becomes more persistent—say, due to wage-price spirals or prolonged trade tensions—the Fed's delayed response could force abrupt policy shifts, destabilizing markets. For now, though, the Fed's inaction has kept the U.S. dollar strong, with the dollar index (DXY) rising to 106.8 in Q2 2025, reflecting its role as a safe-haven asset.

ECB and BoE: A More Aggressive Path to Stabilization

The ECB and BoE have taken a different route. The ECB cut rates by 25 basis points in June 2025, bringing its deposit rate to 2.00%, while the BoE reduced its Bank Rate to 4.25% in May 2025. These cuts were driven by downward revisions to inflation forecasts and the need to offset weaker global demand. The ECB's staff projections now show euro-area inflation averaging 2.0% in 2025, compared to the Fed's 3.1% forecast.

The BoE, meanwhile, faces a delicate balancing act. While it acknowledges that headline CPI inflation will temporarily spike to 3.5% in Q3 2025 due to energy prices, it remains committed to a gradual easing path. This divergence creates a widening gap in interest rate differentials, with U.S. rates remaining elevated relative to European and UK rates.

Implications for Asset Valuations

Equities:
The Fed's rate stability has bolstered U.S. equities, particularly sectors like technology and consumer discretionary, which thrive in low-rate environments. The S&P 500's P/E ratio has expanded to 28x in 2025, driven by expectations of prolonged accommodative policy. In contrast, European and UK equities face headwinds as rate cuts reduce the appeal of domestic bonds, prompting investors to rotate into higher-yielding U.S. assets.

Commodities:
The Fed's “look through” approach has introduced volatility into commodity markets. While energy prices have fallen due to OPEC+ production increases, the ECB's rate cuts have supported demand for industrial commodities. Copper and oil prices have stabilized around $8,500/ton and $82/barrel, respectively, reflecting a tug-of-war between disinflationary and inflationary forces. However, if the Fed's assumption of “transitory” inflation proves wrong, commodities could face downward pressure as global growth slows.

Emerging Markets:
Emerging markets are caught in a crossfire. A strong U.S. dollar, fueled by the Fed's hawkish stance, has increased the cost of EM debt, with the J.P. Morgan EM Local Currency Bond Index falling 4% year-to-date. Meanwhile, the ECB's rate cuts have weakened the euro, making European capital more likely to flow into higher-yielding EM assets. Investors should focus on EM economies with fiscal discipline and export resilience, such as Indonesia and Mexico, rather than those with dollar-heavy debt burdens.

Strategic Positioning for 2025

1. Equities: Overweight U.S. large-cap growth stocks and underweight European cyclical sectors. Use dollar-pegged ETFs to hedge against currency risk in international portfolios.
2. Commodities: Maintain a short-term neutral stance, but consider long-dated options on energy and copper to capitalize on potential volatility.
3. Emerging Markets: Selectively invest in EM sovereign bonds with currency hedges and avoid overexposure to high-debt countries.
4. Fixed Income: Allocate to U.S. Treasuries and inflation-protected securities (TIPS) to benefit from the Fed's prolonged high-rate environment.

Conclusion

The Fed's “look through” approach is not just a technical policy choice—it's a strategic move to anchor inflation expectations in an era of geopolitical uncertainty. However, this divergence from ECB and BoE policies is creating a fragmented global market environment. Investors must navigate this complexity by prioritizing flexibility, hedging currency risks, and staying attuned to the evolving inflation narrative. As 2025 unfolds, the interplay between these divergent paths will likely define the next chapter of global capital flows.