Sky's Ian King says a rate cut due on Thursday in Frankfurt would mark another watershed moment for the European Central Bank, which would stimulate economic growth and help British holidaymakers but also risk spurring inflation.
It will be a pivotal moment if, as expected, the European Central Bank (ECB) cuts its key policy interest rate on Thursday.
On a very basic level, the cut, which is expected to see the ECB reduce deposit rates from 4% to 3.75%, should benefit millions of households and businesses in the euro zone who were previously unaware. Interest level It is the highest price since the single currency was created 25 years ago.
British tourists visiting summer hotspots should also benefit, but it's fair to say foreign exchange markets have been pricing in a rate cut for some time now: the pound has risen 1.5% against the euro since mid-April.
But the move may also have larger implications in terms of what it says about central banks around the world.
Earlier this year, we The Federal Reserve was widely expected to become the first major central bank to cut interest rates.
That would maintain a tradition that has continued almost since World War II of the Fed always tending to cut interest rates before other countries, a tradition that ended in 2011 when the ECB cut rates in response to the euro zone debt crisis while the Fed left its key policy rate, the federal funds rate, unchanged.
A further departure from tradition occurred in 2013 when the ECB began cutting interest rates again while the Fed left them unchanged.
But these were not normal times, and so this week's move marks the first time since the pre-war period that the ECB (or Bundesbank, Europe's most important central bank before EMU) has cut interest rates before the Fed under relatively normal circumstances.
It's worth noting at this point that the ECB is not the only central bank to deviate from the Fed's monetary policy: the Swiss National Bank and Sweden's central bank, the Riksbank, have already cut interest rates this year, and at the time of writing the Bank of Canada is expected to cut rates later on Wednesday as well.
The Bank of England is also expected to start cutting interest rates in August, but in contrast the Fed is not expected to start cutting rates until the final three months of the year.
UK inflation falls to 2.3%
It is worth noting that as well as breaking with the long-term trend in normal economic circumstances, a rate cut by the ECB this week would be doubly unusual, as euro zone inflation remains well above the bank's 2% target — a cut born out of concern about weakness in the euro zone economy.
And monetary policy divergence with the Fed does not come without risks for the ECB.
In particular, we are concerned about how an early ECB rate cut would affect the euro/US dollar exchange rate, which, all else being equal, should weaken the single currency and make eurozone exports to the US more competitively priced.
But this comes with risks: rising import costs, especially energy prices which are priced in dollars, could push up inflation. A weaker euro also carries risks in a U.S. election year where President Joe Biden and his rival Donald Trump are vying for power on protectionist policies.
Mohamed El-Erian, an adviser to Allianz and Gramercy and one of the world's most experienced investors, wrote in the Financial Times last week: “If interest rate divergences are too large and persistent, there is a risk that European currencies will weaken beyond a level where competitive advantage cannot offset the costs of higher imported inflation.”
“With the US in an election year, this could also fuel protectionist tendencies that are already on the brink of intensifying. The combination of the two risks creating financial instability that could spill over and exacerbate economic instability.”
As a result, most market participants do not expect monetary policy divergence to widen significantly.
“Broadly speaking, if you look out to 2024…[there are] Central banks have limited opportunities to ease monetary policy. There is insufficient evidence to support the argument that they can act aggressively in terms of lowering inflation.
“Despite the potential for divergences, the overall message is that overall there is relatively limited room for easing in a world where growth is broadly robust and inflation is still trending downwards but has yet to return to levels central banks are comfortable with.”
That view is shared by strategists at BlackRock, the world's largest asset manager, who wrote in a client note this week that “falling inflation and 18 months of weak economic activity provide a case for the ECB to begin cutting rates, but we do not see them in a rush to make any significant cuts.”
“Similarly in the US, we expect only one or two rate cuts from the Fed this year. This is not a typical rate cutting cycle.”
“Investors may see opportunity in further policy divergence, but this is likely to be temporary as both central banks ultimately plan to keep interest rates high for a longer period.”
The message to euro area households and businesses is therefore that borrowing costs are falling, but perhaps not as much as hoped.
This also applies to Brits enjoying sun loungers in Spain, Greece and other countries this summer – so enjoy the money you've saved up over the holidays now.
