Europe may soon discover the limits of decoupling on rates

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

A major question facing many central banks around the world is no longer whether interest rate policies in advanced countries will decouple in a manner that was thought highly unlikely just a few months ago. They already have and will do so even more.

The question is the scope and size of the potential divergence, and the implications for reconciling domestic economic priorities with the avoidance of harmful exchange rate volatility.

At the start of 2024, markets were looking for the Federal Reserve to lead an interest rate cutting cycle early this year that would timidly extend to other advanced economies. Now, markets are looking for the Fed to limit itself to a single cut this year rather than seven; and also for central banks in Europe to cut earlier and more than their US counterpart. This is despite the European Central Bank, in particular, having started the preceding hiking cycle late and ending up doing less than the Fed’s 5.25 percentage point rise in rates.

This policy interest rate divergence has already started with central bank cuts in the Czech Republic, Hungary and Sweden. It is commonly expected to widen with an ECB cut next week. The Bank of England was set to follow, though the just-announced timing of the election could complicate matters. And all this as market expectations of the now-single Fed cut got pushed back to the end of the year, with quite a few analysts doubting even that.

Both growth and inflation are behind this divergence that some had considered unthinkable at the start of the year.

The weak economic conditions seen in Germany and the UK in 2023 are expected to be followed only by muted growth this year, especially when compared with the US experience. Longer-term growth prospects are also less favourable for Europe. The continent’s approach to growth, with its heavier reliance on traditional manufacturing and relatively high exposure to international demand, needs an urgent revamp.

Such growth reinvigoration is further complicated by the fact that it is not limited to actions by nation authorities. Major pan European initiatives are needed to enhance the future engines of growth (such as artificial intelligence, life sciences and sustainable energy), as well as deal with pressing sectoral gaps including defence, cyber and energy security.

Prices are also decoupling after having reacted to common shocks, both up and down. With a weaker economy, European inflation is anticipated to get closer to the ECB’s target and, in the case of the BoE, even temporarily dip below it. Not so for the Fed where services inflation is expected to be more stubborn.

Despite these growth and inflation considerations, there is a limit to how much interest rate decoupling is feasible (as opposed to desirable). A currency depreciation resulting from growing rate differentials is unlikely to be offset in any material way by European success in attracting capital flows from the US, be they foreign direct or portfolio investments.

As such, too large and persistent a divergence in rates risks weakening European currencies beyond the point where possible competitive advantages compensate for the costs of higher imported inflation. In a US election year, this could also fan protectionist tendencies that, already, are on the cusp of intensifying. The two together would risk financial instability that would spill back to amplify economic concerns.

In sum, it is hard to see the additional differential in policy rates extending beyond 0.50 to 1 percentage points. It is an open question whether this would prove sufficient to meet Europe’s domestic policy priorities. Less uncertain is where the possible reconciliation lies — that is, in the hands of the Fed. 

Other than in times of acute crises, the Fed has been keen to stress that its policy decisions are determined only by domestic considerations; and that this is in the longer-term interest of other countries given the importance of US economic health to the overall wellbeing of the global economy. We should not expect a different approach simply on account of Europe’s policy dilemma.

What would help Europe is a recognition by the Fed that its combination of excessive data dependency and strict adherence to its 2 per cent inflation target could unnecessarily increase the probability of a US hard landing; and that such a downturn would hit poor households and small businesses, already on the ropes, particularly hard in both magnitude and duration. As a Fed adjustment is something to hope for rather than depend on, look for Europe to discover the limits to interest rate divergence by the end of this year.