In Opposition With The Fed

The European Central Bank (ECB) has decreased interest rates by a quarter point, initiating a reversal of its historic rate increases. This move contrasts with the Federal Reserve's current stance, as the Fed is not expected to reduce rates for several months.

  • The ECB announced a reduction of its key interest rate from 4% to 3.75%, marking its first rate cut in nearly five years. Future rate decisions will depend on economic data, and the ECB emphasized that it is not committing to a specific rate path.
  • This rate cut is significant for investors and the global economy, signaling potential relief for households, governments, and businesses burdened by high borrowing costs. It also sets the ECB and the Fed on different trajectories, potentially complicating policymaking in Europe.

Cautious Stance Still Prevails

Despite similar inflationary pressures in wages and services in both Europe and the U.S., Europe's underlying inflation increased to 2.9% last month, while U.S. core inflation decreased to 3.6%. ECB President Christine Lagarde highlighted that inflation remains above the 2% target and that wage growth is still elevated.

  • Lagarde refrained from providing a clear outlook on future rate changes, stating that decisions will depend on incoming data. Investors are closely watching for differences between central banks, which can affect asset and currency markets.
  • Market data suggests the ECB, Fed, and Bank of England might each cut rates by about 0.4 percentage points by year-end, implying one or two more quarter-point cuts for each.

The ECB's decision to cut rates, despite higher-than-expected economic data, reflects a commitment made to the markets. Analysts noted that the ECB was compelled to follow through with the cut even as growth and inflation outpaced expectations.

Boost To The Dollar

A scenario where the ECB continues to cut rates while the Fed holds steady could weaken the euro against the dollar, increasing import costs and eurozone inflation, potentially delaying further rate cuts in Europe.

  • While the U.S. economy has remained resilient despite significant rate hikes, Europe's economy has struggled since late 2022, although there was a slight uptick in growth in early 2023, partly due to a tourism boom in southern Europe.
  • Job creation and wage growth have been strong on both sides of the Atlantic, with wages contributing significantly to services-price inflation in the eurozone.

Earlier this year, both the Fed and the ECB were expected to cut rates similarly.

Global Rates Cuts

However, a resurgence in U.S. inflation altered those expectations, leading some Fed officials to consider additional rate hikes. Fed Chair Jerome Powell remarked on the higher-than-expected U.S. inflation and indicated that any rate cuts would depend on lower inflation or a weakening job market. Despite this, the U.S. economy continues to grow, with a low unemployment rate and robust underlying demand.

  • The ECB's rate cut positions it behind other developed-market central banks like those of Sweden, Switzerland, and Canada, which have already reduced rates this year.
  • The Bank of Japan also remained largely uninvolved in the rate-hiking cycle. The Bank of England is expected to cut rates later this year if inflation remains sticky.
  • Some ECB policymakers, like Austria's central bank governor Robert Holzmann, expressed concerns about fully returning inflation to its target and preferred to keep rates unchanged. Holzmann criticized the decision to cut rates, emphasizing the need for data-driven decisions.

Stefan Gerlach, a former Irish central bank official, noted that by cutting rates, the ECB has shifted the focus from whether there should be a cut to what the future rate path will be, suggesting that the ECB's communication strategy might have been flawed.

Disclaimer

Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

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Photo by Finn Protzmann / Unsplash.