The ECB wedged ahead of the Fed – Has the central banks’ monetary policy started to diverge?

Central banks Both sides of the Atlantic have followed the same choreography in their interest rate decisions for years. The US Fed has set an example and the European ECB has followed suit.

Banks have gone spectacularly in different directions only once in twenty years. In the mid-2010s, the Fed lowered its key interest rate above zero for a few years, but the ECB did not follow suit. It kept its policy rate negative.

Instead, the interest rate hike started by the central banks two years ago proceeded according to the familiar choreography. The Fed started to tighten monetary policy a little before the ECB.

Now, however, the marching order has changed. Both central banks have cut their key interest rates over the past six months, but this time the ECB has run briskly ahead of the Fed. Whereas the Fed has lowered its key interest rate only twice, the ECB has already lowered its rate four times.

Are the monetary policies of central banks that have followed the same tracks for a long time diverging?

Fedin The Open Market Committee, which decides on monetary policy, will announce today, Wednesday (December 18), whether the central bank will cut its key interest rate for the third time this year.

Investors are betting it will cut. But at the same time, the rate cut may be the Fed’s last, if not the last.

The central bank is unlikely to be ready for a significant easing of monetary policy next year. The risk is that inflation will accelerate again.

“Inflation always reflects the prevailing economic situation,” says the Forecasting Manager Päivi Puonti From the Business Research Institute Etla.

“The acceleration of inflation is a sign that the economy is doing well. When the economy does worse, inflationary pressures disappear.”

There is now a strong growth trend in the US economy, and the Fed should therefore not conditionally continue interest rate cuts.

“The United States has fared better than Europe in recent years, if only because it has not had to suffer the economic effects of Russia’s war of aggression, according to European law,” says Puonti.

of the euro area something like a Christmas miracle would have to happen in the economy in order for the ECB’s fourth rate cut to be the last.

According to the central bank’s latest economic forecast, the euro area economy will recover more slowly than expected. Due to fragile economic growth, the ECB will continue to ease monetary policy next year as well.

At some point, the rounds in the euro area economy will inevitably start to increase, when the interest rate cuts are transmitted to the economy with their full force and financial conditions ease even more.

Still, the start of economic growth seems, at least based on the market’s view, to require several more interest rate cuts from the ECB. Namely, the market expects the key interest rate to be 1.75–2.00 percent a year from now, while it is now 3.0 percent.

Today The European Central Bank’s pace of interest rate cuts, rivaling that of the US Federal Reserve, which began in 2010, will probably continue next year. The Fed, on the other hand, may refrain from interest rate cuts next year even completely.

However, it is still difficult to establish the divergence of monetary policies at this point. It may be that central banks move in different directions for only a few years, like in the 2010s, and then start to follow each other again.

On the other hand, certain burgeoning development costs in the euro area economy, if intensified, may lead to a situation where the ECB has to bring its policy rate clearly closer to the zero limit than the Fed.

From the point of view of both monetary policy and the economic development of the euro area, for example, it is of great importance whether the Alho of the euro area industry will continue even after the economic cycle has improved.

of the euro area industrial production has been shrinking practically continuously for almost two years now.

The single most important reason for the industry’s decline is the increase in energy costs resulting from the 2022 energy crisis.

The energy crisis has had a long tail, says the office manager of the Bank of Finland’s monetary policy and research department Markku Lehmus.

“The price of energy seems to have remained permanently high, and it has hit energy-intensive industry, which there are still a lot of in Europe.”

The weakening of industry is critical in the sense that industry has traditionally been the engine of productivity growth in the euro area.

The contraction of industrial production now threatens to slow down productivity growth, so that an increasingly larger share of the euro area’s total output comes from service sectors, where labor productivity is typically lower than in industry.

Eurozone has already suffered from slow productivity growth.

Former President of the European Central Bank Mario Draghi in its report published in the fall, named slow productivity growth as the main reason why Europe has been lagging economically behind the United States for a longer time.

Productivity growth is the most important source of economic growth. Therefore, its slowdown is holding back economic growth.

“If economic growth slows down, the euro area would once again drift into a situation where the central bank has to revive a weak economy with monetary policy,” says Etlan Puonti.

In that case, the ECB might have to push its key interest rate back closer to zero. In the daily life of Finnish mortgage borrowers, this would naturally be reflected in a decrease in interest expenses, but more broadly in terms of the economy, a return to zero interest rates would be by no means desirable.

However, the above is only a scenario if things go badly. Bank of Finland’s Lehmus would like to be more optimistic about the future.

“High value-added companies can appear in the European service sector, in other words, technology companies, which will increase productivity in the service sector as well.”

Lehmus according to it is generally a positive sign that the problems of the European economy have been acknowledged several times in the public debate during the past autumn.

“With Dragh’s report, a discussion has started about how the problems could be solved. The moment is approaching, when we start to get things done.”

Nor is it written in the stars that the US economy will continue to flounder and that the Fed will not have to worry about anything other than price stability.

To start his presidential term in January Donald Trump’s politics can have damaging consequences for the economy.

For example, if Trump fulfills his promise of tax cuts and his threat of import tariffs, inflation will almost certainly run wild again. In particular, the rise in consumer prices caused by customs duties would affect the economy as a slowdown in growth.

All in all, Trump’s rise to power portends uncertainty, which is rarely a positive thing for the economy.