Diverging fortunes in U.S. and Europe signal widening interest-rate gap
The Federal Reserve is likely to raise short-term interest rates this week while the ECB could signal it won’t start raising rates for some time
Central banks in the U.S. and Europe are both expected to move this week to unwind stimulus policies adopted since the global financial crisis a decade ago.
But the likely steps mask a recent divergence in the fortunes of the world’s top two economic blocs, which looks set to keep the central banks on different interest-rate tracks for many months to come.
The Federal Reserve is likely to raise short-term U.S. interest rates Wednesday and pencil in more increases in coming years, to keep the U.S. economy from over-heating, The ECB could signal on Thursday it won’t start raising rates for some time even as it moves to phase out its $2.5 trillion ($3.25 trillion Canadian) bond-buying program.
ECB officials are pondering the causes of a recent slowdown in eurozone growth that appears to have continued through the spring, as well as the risks posed by international trade spats, higher oil prices and political turbulence in the bloc’s number-three economy, Italy.
The gap between the two central banks’ key policy rates is expected to widen to around 3 percentage points by the end of next year, from around 2 percentage points today, according to forecasts by Fed officials and investors. That would be the biggest gap since late 2008, when the Fed cut its short-term interest rates far below those of the ECB as it reacted to the subprime crisis.
“With some uptick in political uncertainty, and inflation still below target in the euro area and Japan, monetary policies among the advanced economies look likely to be divergent for some time,” said Fed governor Lael Brainard in a speech last month.
That reflects different economic fortunes: The eurozone economy currently appears to be growing at half the speed of the U.S. after outpacing its trans-Atlantic counterpart over the past two years. The American economy, fanned by the recent tax cuts, could grow by more than a 4 per cent annual rate in the second quarter, according to Atlanta Fed projections, the fastest since 2014. Unemployment hit 3.8 per cent in May, the lowest in 18 years, and inflation has reached the Fed’s 2 per cent target after undershooting it for much of the past six years.
In the 19-nation eurozone, where second-quarter growth is expected to be around 2 per cent, the ECB has signalled it could announce as soon as this week plans to phase out its bond-purchase program, known as quantitative easing, which is credited with supporting the region’s economic recovery.
But analysts say that move is probably necessary because the ECB is approaching the limits of what it can buy under rules aimed at limiting the impact on markets, and ensuring the program doesn’t finance eurozone governments.
Despite an oil-fueled bump in headline inflation, underlying inflation in the region is hovering around 1 per cent, far below the bank’s target of just below 2 per cent. ECB officials have emphasized recently that the bank’s monetary policy will remain very loose even after the end of QE, and hinted it might take longer to raise interest rates.
Some investors had until recently expected the ECB to start raising interest rates this year, but most now don’t see a first rate hike until late next year.
“The end of the buying program does not automatically mean an early rate hike, let alone a real rate-hiking cycle,” said Joerg Kraemer, chief economist with Commerzbank in Frankfurt.
In the U.S., the Fed raised rates three times last year after only moving once in each of the previous two years. In Europe, ECB president Mario Draghi signalled for the first time last June that the central bank would gradually phase out its monetary stimulus as eurozone growth accelerated, triggering a protracted appreciation of the euro.
Europe’s recovery has since hit a soft patch. Growth slowed to an annualized rate of 1.6% in the first quarter of this year, down from 2.8 per cent in the fourth quarter of last year. ECB officials have highlighted a number of temporary hindrances including cold weather and an outbreak of flu, but recent economic data doesn’t show much improvement.
A political crisis in Italy last month sent bond markets swinging wildly and raised fears that the new populist government could push the country out of the eurozone. Rising oil prices and the threat of trade wars have also raised concern in Europe and around the world.
The U.S., by contrast has been better insulated, partly because its economy is less reliant on trade and because it is one of the world’s top oil producers.
Another reason for the transAtlantic divergence is that the U.S. economy has been growing for much longer than the eurozone: The current U.S. expansion is almost nine years old and the nation’s second longest on record, but it is only five years since the currency union exited recession.
The Fed stopped buying assets on a large scale in 2014 and began raising rates in 2015. The ECB is only now considering winding down its bond purchases.
The two central banks may also be haunted by past mistakes, said Marcel Fratzscher, president of German economic think tank DIW.
The Fed kept interest rates too low between 2002 and 2005, helping to stoke an asset-price bubble that ended in the global financial crisis, Mr. Fratzscher said. By contrast, the ECB has been criticized for increasing interest rates prematurely in 2008 and again in 2011, in an effort to control inflation — just before the eurozone collapsed into recession.