Europe's economic divergence with US is real but has limits
Inflation in the eurozone is different to that in the US, much as the European Central Bank (ECB) President Christine Lagarde insists, but the bloc will still face many of the same headwinds as others, limiting how far price growth can slow.
The ECB put an interest rate cut in June on the table last week, arguing that price growth was decelerating towards 2 per cent and the 20-nation bloc was "not the same" as the US, which is struggling with unexpectedly stubborn inflation that may delay interest rate cuts there.
While numerous differences underscore Lagarde's point, Europe does not exist in a vacuum and problems in the US are bound to make their way across the Atlantic, albeit over time and in a more muted form, economists say.
Two fresh surveys by the ECB published last week reveal the contrast – one suggesting eurozone growth will be barely above zero this year, and another showing the bloc's biggest firms see contracting investments, workforce cuts and poor retail sales.
This is pushing the long expected recovery further and further out, and even if the economy seems to have bottomed out, the tentative signs of demand and sentiment recovery point only to a gradual and muted rebound.
Annualised growth in the US, meanwhile, was above 3 per cent in the final quarter of 2023 and inflation was driven primarily by demand.
"We remain convinced that, given wildly different demand/consumption backdrops in the euro area and US, US demand-driven inflation can sustainably diverge from mostly supply-driven euro area inflation," TS Lombard's Davide Oneglia said.
Indeed, goods inflation is just 1.1 per cent in the eurozone and data out of France and Germany last week showed that manufactured goods prices lowered the headline figure.
While trade is rebounding from low levels, monthly import figures show a jump in trade with China in early 2024 and given weak domestic demand, these fresh imports are disinflationary.
In contrast, US consumer demand remains so strong that any fresh import has better pricing power.
Fiscal policy is another key factor in the divergence. While the US government could run a budget deficit of 5.6 per cent of GDP this year with a further increase in 2025, the fiscal impulse in the eurozone is shrinking, with the budget deficit seen down at 2.9 per cent this year before another drop in 2025.
The labour market is also crucial. Eurozone unemployment may be at a historic low, but broader measures of slack which also count underemployment stand at around 11 per cent versus just above 7 per cent in the US.
More importantly, while much of the eurozone's high employment is a factor of labour hoarding by firms who fear a loss of skilled workers, the US continues to create new jobs much faster than expected.
High interest rates also tend to feed into US housing costs much quicker than in Europe, a key reason why "shelter" inflation is above 5 per cent.
Still, Europe will suffer commodity price increases much like everybody else or possibly even more given that it is a net importer.
Energy has been the biggest drag on inflation this year, but crude oil is up 14 per cent since the start of 2024 and this will start adding to prices in the second half of the year, even as natural gas prices hold broadly steady.
In addition, expectations of faster eurozone rate cuts have already weakened the euro, and this raises the prices of imported goods, thereby lifting consumer prices.
Weakening labour productivity could also add to Europe's inflation since it means greater unit labour costs that must eventually find their way into consumer prices.
"We disagree with what Christine Lagarde said regarding US inflation and the full decoupling of eurozone inflation developments from those in the US," ING economist Carsten Brzeski said.
"Headline inflation developments in the US have nicely led eurozone developments with a lag of around half a year; not necessarily the exact monthly inflation numbers, but definitely the broader direction of inflation."
Nevertheless, the divergence is clear and the ECB will be able to lower interest rates before the Fed, even if it will be buffeted by the same headwinds, limiting its ability to go it alone.
"Given the relative data flow – slower growth, lower inflation, tighter fiscal policy – the ECB has the basis to act independently of the Fed and ease in June and maybe several times this year," Deutsche Bank said.
"However, there are likely to be limits to the ECB’S independence from the Fed over time to the extent that the euro area and US are large trading partners of one another."
We remain convinced that, given wildly different demand/consumption backdrops in the euro area and US, US demand-driven inflation can sustainably diverge from mostly supply-driven euro area inflation."
TS Lombard's Davide Oneglia