Imagine standing in the Dutch polder, gazing at a sky illuminated by the ethereal northern lights. It’s a rare event, almost as rare as the European Central Bank (ECB) adjusting interest rates before the U.S. Federal Reserve (Fed). Yet, this unusual monetary phenomenon is set to occur when the ECB convenes in June to discuss interest rates.
The root of this exceptional situation lies in the diverging paths of the U.S. and eurozone economies post-pandemic. The U.S. economy is booming, unemployment is at historic lows, and the government continues to inject funds, keeping inflation stubbornly high. Conversely, the eurozone is slowly shaking off a year-long stagnation, with lower and slightly less persistent inflation compared to the U.S.
In this context, the ECB has a plausible case for cutting interest rates, while the Fed, if considering any change, would likely raise them. Minutes from the Fed’s latest meeting reveal a willingness to hike rates if inflation doesn’t retreat.
However, the ECB’s room for rate cuts is uncertain. Typically, when a central bank starts lowering rates, it does so multiple times—four or five, if not more. Financial markets have already priced in one or two ECB rate cuts, affecting the euro’s exchange rate. A weakened euro results from a widening interest rate differential between the eurozone and the U.S., making the dollar more attractive due to its higher interest rates.
If the ECB were to cut rates more frequently, the euro would only avoid further weakening if the Fed also starts cutting rates. Without reciprocal action from the Fed, more than two ECB rate cuts would significantly weaken the euro. This scenario could backfire, importing inflation through more expensive eurozone imports like oil and gas due to the weaker currency.
The likelihood of the Fed making U.S. borrowing cheaper soon is slim. Economic and inflationary trends don’t support it. Recently, Fed Chairman Jerome Powell, during his visit to Amsterdam, described the U.S. labor market as “very, very strong,” emphasizing that rate cuts are off the table until the labor market normalizes—a distant prospect according to Powell.
Thus, the Fed’s stance effectively constrains the ECB’s ability to cut rates. This predicament echoes the 1970s when the U.S. Treasury Secretary told frustrated European counterparts, “The dollar is our currency, but your problem.” Today, we might say, “Our interest rate is our interest rate, but it’s your problem,” highlighting the ECB’s challenging position.
Edin Mujagić, chief economist at OHV Asset Management and author of “Turning Point 1971,” provides monthly insights on ECB policy for Investment Officer.