It is divergence time. The European Central Bank is expected to start cutting interest rates in less than a month, while the Federal Reserve is on hold for some time.
Even though Fed chair Jay Powell was not as hawkish as markets feared, the transatlantic gap in rates is likely to grow. When asked about divergence in his press conference last week, Powell said the obvious.
“We all serve domestic mandates, right?” he said. Inflation performance was similar, he added, but Europe is “just not having the kind of growth we’re having”.
Many in Europe disagree about the similarity of the inflation trends, but senior officials at the ECB agree on the important issue. Interest rates are about to diverge. As president Christine Lagarde said last month, “we are data dependent, we are not Fed dependent”.
Within the Eurozone, however, there is some tension over the looming transatlantic divergence. Let’s call it a trans-Adriatic divide.
Boris Vujčić, governor of the Croatian National Bank, said that the ECB could move first and would look at domestic data, but he warned, “the longer a possible gap between us and the Fed widens, the more impact it is likely to have”. The implication was that there were limits to the possible divergence.
His Italian counterpart, Fabio Panetta, however, sees things differently. Higher Fed rates for longer would tighten global financial conditions, he said, strengthening the case for Eurozone rate cuts. “If markets expect interest rates to drop but the Fed keeps them unchanged . . . the rest of the world faces an unexpected monetary tightening.”
Who is right?
Transatlantic interest rate divergence
Since the advent of the euro, global interest rates have tended to move broadly in sync. The big moves in interest rates, such as the cuts in the early 2000s, during the financial crisis in 2008 and the increases after the Covid pandemic, have been global.
But, as the chart below shows, there were two principal periods of difference. The US was much faster to raise interest rates from 2004 and from 2016. In each case, US economic activity was stronger and appeared to be generating more inflationary pressure.
Although there were global economic crises following both of these periods, I am just going to assert that the interest rate differentials were not the cause. Email me if you disagree.
What is the potential problem with divergence?
As Powell stated above, the US sees no problem in divergence. It sets its interest rate according to its domestic inflation and employment mandate and allows the US dollar to float freely.
This has often been a particular problem for emerging markets, where US interest rates can create massive capital flows and currency movements, leaving their central banks following the Fed and setting monetary policy inappropriate for their domestic economies. It can be tough.
But the Eurozone (and to a lesser extent, the UK) is different. It is a large economy and it can clearly set its own monetary policy if it so desires.
The empirical question is therefore threefold. First, do financial conditions diverge on either side of the Atlantic? Second, do interest rate differentials have a significant effect on the value of the euro? And third, what is the effect of the euro’s value on domestic demand and inflation?
Do we see financial conditions diverging?
The short answer is yes. The chart below shows the market expectations of interest rates for the end of 2024 in Europe and the US. A year ago, markets expected both the ECB and the Fed’s interest rates to be a little above 2.75 per cent by December 2024. While the expectations for the Eurozone have drifted higher to about 3.25 per cent, those for the Fed have shot up to about 5 per cent.
The expected interest rate differential in December 2024 has jumped from 0.1 percentage points a year ago to 1.8 percentage points now.
The same analysis for the Bank of England is different. A year ago, the UK was thought to be an inflation basket case and interest rates were expected to stay higher than those in the US. But since the autumn, market interest rate expectations for the BoE and Fed have converged and ever since have moved in lockstep.
The pattern is the same for the end of 2025.
These market movements suggest that the Eurozone’s financial conditions are not set by the Fed. The same cannot be said with so much confidence for the UK, where movements in expected Fed rates have translated to UK expected interest rates almost regardless of Britain’s economic circumstances of late.
Do differential interest rate expectations move exchange rates?
Again, there is a short answer: not very much. In the last chart we saw divergence in expectations for Fed and ECB interest rates with convergence in UK US rates. Alongside these significant changes, neither the spot exchange rates, nor future exchange rates, showed large swings. The chart shows little correlation between movements of expected interest rate differentials for the end of 2024 and 2025 and expected movements in currency valuations.
Once again, this demonstrates that predicting currency movements (especially from expected interest rate changes) is a mug’s game. Yes — the future value of the euro is down a bit when the interest rate differential rose, but this is not a currency shift that should stop Lagarde sleeping soundly.
What is the effect of currency movements on inflation?
Financial markets are not expecting large transatlantic currency movements, but these things can just happen. Knowing the size of effect is an important thing to have in the back of your mind.
The ECB has done quite a lot of work on this and the broad answer is “small”. The scale of the exchange rate impact on inflation and GDP has weakened since 1999, according to the ECB research, but the exact size depends on the cause of the exchange rate movement. The last point is important.
To get a visual representation of the small scale of effects, the ECB published the chart below. It shows that exchange rate movements (inverted and on the left axis) had a material but much smaller effect on import prices and producer prices, but barely any effect on core goods inflation.
Of course, the eagle-eyed will notice this chart was produced before the pandemic and recent inflation. An updated version below does not destroy the result, even if the scales need to be changed a lot.
Exchange rates do not have big effects, but huge global supply chain shocks do. This chart below also shows that energy price shocks can bleed into core producer and consumer prices.
The upshot for the ECB
The world is uncertain, but the ECB should not be frightened by the prospect of reducing interest rates ahead of the Fed.
The evidence from market pricing of interest rates and exchange rates is that divergence will be orderly. Financial markets are expecting it because inflation is less of a concern in the eurozone and growth has been weaker. This applies even after the slightly better-than-feared first quarter Eurozone GDP figures.
The ECB can go it alone with rate cuts, while monitoring the data and financial markets to respond to events.
. . . and for the BoE
If it was brave, the BoE would cut rates even earlier than the ECB. That means on Thursday this week. There is more evidence the UK’s financial conditions are being set in Washington rather than London, and this is inappropriate for a European economy with feeble economic activity and falling inflationary pressure.
The latest inflation data was not great, so we can probably expect the BoE to hold rates on Thursday, while perhaps signalling a June cut. But there are two possible reasons why the bank might act.
First, governor Andrew Bailey and his colleagues loved talking about how they raised interest rates ahead of the ECB and Fed in late 2021. They might want an encore.
Second, the sharp move up in expected BoE interest rates since January will make a mess of the bank’s forecasts and add to its difficulties in communication. Expect lower inflation in the headline predictions. This might prompt action.
What I’ve been reading and watching
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Mohamed El-Erian welcomes the softer than feared inflation rhetoric from Powell. He predicts that US inflation will remain close to 3 per cent in this opinion piece and suggests that is a good outcome after last week’s FOMC meeting
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Lord King will have made himself unpopular again at the BoE after the former governor slammed recent UK and US monetary policy for ignoring movements in monetary aggregates
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Head of the Bank for International Settlements, Agustín Carstens, tells Rob Armstrong that central banks are doing well in a bumpy final mile fighting inflation
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In the UK, politicians on the Treasury committee are beginning to get concerned by “the staggering scale of unanticipated income high street banks are bringing in, with no work required, as a result of increased interest rates”. This is no surprise
A chart that matters
Financial market expectations of interest rates can sometimes be difficult to show graphically. I devised this chart for the US, showing the number of rate cuts expected in 2024 and 2025. There has not been much change of view for next year, but a massive change of view this year. As a graphical tool, do you like it?
