European Central Bank officials are expected to cut interest rates this week for the first time in more than five years, ending the worst of the euro zone's inflation crisis and easing pressure on the region's weak economies.
But as euro zone policymakers forge ahead, they are lagging behind their counterparts at the U.S. Federal Reserve, who are tackling deeper-rooted inflation problems and warning that any rate cuts will take longer.
If Europe cuts interest rates before the U.S., it will create a rift between the policies of the world's two largest and most influential central banks. An easing of policy by the ECB could weaken the euro, while higher U.S. interest rates would mean the dollar's global role would continue to tighten financial conditions in the U.S. and elsewhere.
Some analysts have questioned how far the ECB can diverge from the Fed, while others say divergence is not unusual and reflects the reality of two different economies.
“After more than a year of stagnation in Europe, there are signs that deinflation is on track,” said Mariano Sina, an economist at Barclays Plc. “This is a very low starting point for the economy.”
In contrast, the U.S. economy has been performing well over the past few quarters.
“There are already divergences in the economies,” he said, “so if there are divergences in policy, it's because the economies are on different trajectories.”
While the ECB stresses that it will not act solely on the actions of the Fed, policymakers acknowledge that they cannot ignore the Fed's influence on financial conditions and exchange rates around the world.
“Monetary policy operates within a global context,” said Frederic Ducrozet, head of macroeconomic research at Pictet Wealth Management. “If the global context changes because of the U.S., China, tariffs, etc., the ECB has to take that into account.”
The ECB signaled its intention to cut interest rates this Thursday from 4% to 3.75%, the highest on the central bank's record and the highest since September. Inflation is forecast to bounce back sustainably to the bank's 2% target next year as the shock from rising energy prices following Russia's invasion of Ukraine fades.
European Union inflation rose to 2.6% in May, slightly up from the previous month but significantly slower from a peak of more than 10% in the second half of 2022.
The euro zone economy is still struggling with the effects of high interest rates introduced to combat high inflation. After five quarters of stagnation, it grew just 0.3% in the first quarter of this year, manufacturing is shrinking and demand for credit for business expansion and home purchases has fallen sharply.
But in the United States, strong demand is fuelling inflation and Fed officials are finding it harder to rein in the economy. Consumer prices rose 3.4% in April from a year earlier.
“What both regions have in common is the uncertainty about the inflation outlook,” Ducrozet said, but added that “the potential for divergence remains very strong.”
The ECB and Fed have differed before, including around the time of the 2008 financial crisis. The gap widened for another five years in 2014 when the ECB introduced negative interest rates and a massive bond-buying program as Europe struggled with deflation and a regional sovereign-debt crisis.
This time around, the divergence is expected to last only long enough for the Fed to start cutting rates. The two central banks are not expected to move in opposite directions, especially after April U.S. inflation data showed welcome signs of a gradual decline in prices and consumer spending.
That would allay one of investors' biggest concerns about the ECB acting ahead of the Fed: that the euro would fall against the U.S. dollar and the region would import inflation through its exchange rate.If the ECB acts in line with traders' expectations, exchange rates shouldn't fluctuate too much, Mr. Sina said.
The ECB is expected to cut interest rates just a few times this year, cutting them by a quarter of a percentage point each quarter, which will still curb the economy.The caution is justified: Inflation in the euro zone's services sector, which is heavily dependent on wages, accelerated to 4.1% in May from 3.7% the previous month.
“That's something that will raise eyebrows,” said Joumana Saleheen, Vanguard's chief European economist.
Services inflation is showing little sign of slowing. “It's worrying, but not alarming,” Saleheen said, adding that other components of inflation, such as food and goods, have slowed significantly. He expects the ECB to cut interest rates three times this year.
“The overall news is good,” she said. “The worst is over in Europe, the stagnation is over, and we are now heading towards a period where we can get back to a growth trend.”
Still, analysts say there are limits to how much the ECB can do without the Fed.
“The longer the Fed puts off cutting rates, the harder it could ultimately be for the ECB,” Ducrozet said, adding that things would get even tougher “if the Fed doesn't cut rates at all, or, even worse, if the Fed starts to genuinely worry that the election will lead to a new wave of inflationary pressures.”
