European Central Bank officials are expected to cut interest rates this week for the first time in more than five years, ending the worst of the euro zone’s inflation crisis and easing pressure on the region’s weak economy.
But as eurozone policymakers move forward, they are leaving behind their counterparts at the U.S. Federal Reserve, who are grappling with a seemingly more persistent inflation problem and warning that it will take longer to cut rates there.
Cutting interest rates in Europe before the United States does so would create a wedge between the policies of two of the world’s largest and most influential central banks. A move by the ECB to ease its policy could weaken the euro, while higher interest rates in the United States would continue to tighten financial conditions there and in other countries due to the dollar’s global role.
Some analysts have questioned the extent to which the ECB can diverge from the Federal Reserve, while others say a divergence is not unusual and reflects two different economic situations.
“We are coming from a stagnation of more than a year” in Europe with signs that disinflation is on the right track, said Mariano Cena, an economist at Barclays. “This is a very low starting point for an economy.”
By contrast, the U.S. economy has boomed in recent quarters.
“There have already been divergences in the economies,” he said. “So if there is divergence in policy, it is because it follows the different trajectories of the economies.”
Although the ECB has stressed that it does not act simply based on what the Federal Reserve does, policymakers recognize that they cannot ignore the influence the Fed has on financial conditions and exchange rates around the world.
“Monetary policy operates in a global context,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “If the global context changes because of the United States, China, tariffs or whatever, then the ECB has to take that into account.”
The ECB has strongly telegraphed its intention to lower its key interest rate this Thursday, taking it to 3.75 percent from 4 percent, the highest in the central bank’s history and where it has been since September. Inflation is forecast to return sustainably to the bank’s 2 percent target next year as the impact of high energy prices following Russia’s invasion of Ukraine fades.
The bloc’s inflation rate was 2.6 percent in May, slightly higher than the previous month, but has slowed significantly from its peak of over 10 percent in late 2022.
The eurozone economy is still recovering from the effects of high interest rates that were implemented to combat high inflation. It grew just 0.3 percent in the first quarter of the year after five quarters of stagnation, the manufacturing sector is contracting and there has been a substantial decline in demand for loans to expand businesses and buy homes.
But in the United States, Federal Reserve officials are finding it harder to control the economy, where inflation has been driven by strong demand. The Consumer Price Index rose 3.4 percent in April from a year earlier.
“What both regions have in common is that there is uncertainty” about the inflation outlook, Ducrozet said. But, he added, “the case for divergence remains very strong.”
The ECB and the Federal Reserve have diverged in the past, such as in the years before and after the 2008 financial crisis. In 2014, as Europe struggled with deflation and the region’s sovereign debt crisis, the gap grew for several more years. five years when the ECB introduced negative interest rates and a large bond-buying program.
This time, the divergence is expected to last only as long as it takes the Federal Reserve to start cutting rates. The two central banks are not expected to move in opposite directions, especially after a measure of US inflation in April provided some welcome signs of a modest cooling in prices and consumer spending.
That would calm one of the biggest concerns investors have about the ECB’s advance on the Federal Reserve: that the euro could weaken against the U.S. dollar and that the region imports inflation through its exchange rate. If the ECB delivers what traders anticipate, the exchange rate should not move much, Cena said.
The ECB is expected to make only a few rate cuts this year, just a quarter-point reduction once a quarter, which would still tighten the economy. There is a justification for the cautious approach: Inflation in the euro zone’s services sector, a stubborn category heavily influenced by wages, accelerated to 4.1 percent in May, from 3.7 percent the previous month.
“That’s something that caught attention,” said Jumana Saleheen, chief European economist at Vanguard.
Services inflation does not show many signs of slowing down. “It’s worrying, but not alarming,” Saleheen said, adding that other components of inflation, such as food and goods, had slowed substantially. She expects the ECB to cut rates three times this year.
“Overall, it’s good news,” he said. “In Europe, the worst is over, we have ended stagnation and are now moving towards a period in which we can return to the growth trend.”
Still, analysts say there are limits to how far the ECB could go without the Federal Reserve.
“The longer the Fed cuts are postponed, the more difficult it may eventually become for the ECB,” Ducrozet said, adding that the situation would become more difficult “if the Fed does not make any cuts or, worse still, if they start to do it”. “I’m really worried that the election will lead to another wave of inflationary pressure.”