Monetary Policy May Diverge in US and Europe
Markets anticipate that the Federal Reserve's monetary policy will significantly diverge from the European Central Bank's next year, as higher economic growth and inflation expectations in the United States will exacerbate the differences between the two major economies.
Market pricing indicates that by the end of next year, the Federal Reserve's rate cuts will only be half of the European Central Bank's, which is grappling with sluggish economic growth and inflation below target.
According to forecasts compiled by Consensus Economics, as preparations for tax cuts and increased tariffs, the United States' inflation rate is expected to remain above 2% throughout 2025. In contrast, the eurozone's inflation rate is expected to fall below the European Central Bank's 2% target as early as February next year.
Jennifer McKeown, Chief Global Economist at Capital Economics, said: "We expect the Federal Reserve to adopt a rather cautious stance due to rising inflation risks, while the European Central Bank will react strongly to economic weakness, leading to a divergence in their easing cycles."
This divergence highlights the increasing concerns facing the eurozone economy, with policymakers worried that a potential trade war could further damage the region's economy.
Over the past three years, inflation and monetary policy have generally moved in sync across much of the world as all economies experienced rising prices. However, the initial easing measures by the Federal Reserve, European Central Bank, Bank of England, and other Western central banks this year may give way to a more discordant approach in 2025.
Advertisement
Due to heightened concerns about a resurgence in inflation, the two-year U.S. Treasury yield has risen from 3.6% at the beginning of last month to 4.4% over the weekend.
The dollar's trajectory has reversed, with interest rates being one of the driving factors. The dollar has been weakening since the summer, and it has rebounded sharply against other major currencies as investors anticipated that tariff and tax policies would strengthen the dollar.
This has driven the euro to near its lowest point in two years, marking the largest sell-off since the 2022 energy crisis. Weak economic data further exacerbated the euro's turmoil, raising the likelihood of a 50 basis point rate cut by the European Central Bank at its next meeting.
Samuel Tombs, an economist at Pantheon Macroeconomics, said that the U.S. unemployment rate remains low enough and inflation expectations high enough, "indicating that a resurgence in inflation could be possible."
He added: "If his agenda is implemented swiftly, it is conceivable that the Federal Reserve may have to end its easing cycle ahead of schedule."
Barkin, the Richmond Fed President and this year's FOMC voter, said that bringing interest rates back to a more 'neutral' level that no longer suppresses growth to continue fighting inflation pressures "may happen quite slowly."
According to data from Consensus Economics, economists now forecast a U.S. economic growth rate of 2.7% for 2024, higher than the less than 1% predicted in October 2023. For next year, economists have revised their U.S. economic growth forecast to 1.9%, higher than the 1.6% expected in March.
In the eurozone, growth forecasts have been revised down to 0.7% for this year and 1.1% for next year. This summer, economists had expected a growth rate of 1.4% for the eurozone in 2025. McKeown said that some business surveys indicate that the eurozone economy may fall into recession, "which would contrast sharply with the resilience of the U.S. economy."
Markets expect that by the end of next year, the European Central Bank will cut rates by more than 1.5%. This would bring the deposit rate down from the current 3.25% to 2% as early as June and further reduced by the end of the year. Economists surveyed by Consensus Economics forecast a median deposit rate of 2.15% by December 2025.
In contrast, markets expect that by the end of next year, the Federal Reserve will cut rates by less than 0.7% from the current 4.5%-4.75%. The median rate forecasted by economists is 3.375%.
Andrej Svec, an economist at Nomura Securities, said: "The European Central Bank's focus is increasingly shifting towards concerns about economic growth rather than inflation concerns. Ultimately, we believe the European Central Bank will be forced to cut rates below neutral to support the economy."