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The author is chief economist at the Edmond de Rothschild Group and a member of the private bank's global investment committee.
Christine Lagarde's latest signal is that the European Central Bank may start its rate cutting cycle sooner than the US Federal Reserve. The ECB president said last month that absent a “major development shock,” the central bank was at the point where it would have to ease its restrictive monetary policy.
Lagarde stressed that the ECB is not “dependent on the Fed” to decide on the transition. Markets are watching closely, with investors pricing in a cut in the benchmark deposit rate from its record high of 4% as early as next month, with the possibility of two more cuts this year.
In contrast, markets are pricing in the Fed's long-term high interest rate policy, with one rate cut likely in September or November, and another likely later this year. . Fed Chairman Jerome Powell said last week that “it will take more time to have confidence that we are on a sustainable path to 2% inflation.”
The ECB's approach is justified by the fact that weak GDP growth in the euro area is leading to a disinflationary process that is proceeding in line with the central bank's expectations.
However, if the ECB diverges too much from the Federal Reserve, which controls interest rate policy, there are risks to both growth and inflation. This move could backfire. Eurozone central banks have previously cut interest rates ahead of the Fed in April 1999 and November 2011. However, the situation is very different for three reasons.
First, the possibility of a weaker euro after a rate cut risks higher imported inflation as dollar-denominated goods and services translate into a weaker euro area currency.
The energy price situation is particularly unfavorable in this regard, given the EU's dependence on imported energy. Approximately two-thirds of energy demand is met through net imports. China's figure is just 21%. As for the United States, we produce more energy than we consume. Further increases in energy prices would weigh on business investment in the short term, offsetting the expected positive impact on private investment from interest rate cuts.
Second, cutting rates before the Fed would strengthen the market's impression that the ECB expects economic performance to deteriorate. The eurozone's economic performance is already among the worst among developed countries. Economic growth in the euro zone was 0.3% in the first quarter, compared to 0.4% in the United States.
Given the Delphic nature of the central bank market, any indication that the ECB expects further weakness could make the private sector even more pessimistic about the future. This will in turn put pressure on household and corporate investment.
Last but not least, the ECB's credibility is already lower than the Fed's and risks worsening if it acts prematurely.
If the Fed delays the start of its easing cycle, it will no doubt put pressure on the ECB and force it to pause, potentially dealing a blow to long-term confidence in euro area central banks' rate-setting decisions. This could lead to expectations of greater volatility in inflation and GDP growth. Econometric models show that central bank credibility depends more on monetary policy decisions than on GDP or inflation forecast errors.
So even if all the conditions are in place for it to begin cutting rates before the Fed, it would be risky for the ECB to change its central bank batting order.
A better response to economic downturns should come from a fiscal perspective. One potential source of financial support could be as yet unspent European funds allocated under the flagship EUR800 billion post-pandemic EU Next Generation Recovery Programme. It is clear that spending will need to be done carefully to avoid waste and corruption, but leveraging the funds could be more effective than cutting interest rates. As of the beginning of this year, only one-third of his available loans and grants have been disbursed. Even better, tax credits for investments may be the key to increasing the productivity of low capital.
As Japan's precedent has shown, using monetary policy as a means of compensating for the structural growth gap with developed countries carries the risk of a prolonged depreciation of the euro.
This article has been amended to clarify the U.S. and euro area GDP growth data cited. Due to an editorial error, an earlier version quoted annualized quarterly figures for the United States, but not for the Eurozone.
