Central banks go it alone on interest rate easing

Early in June, the European Central Bank (ECB) cut its deposit facility rate by a quarter of a percentage point to 3.75%, signalling growing confidence that - barring the occasional skirmish - the war against inflation is being won.

A week later, the Federal Reserve (Fed) declined to follow suit, leaving its benchmark interest rate on hold at a range between 5.25% and 5.5%. US policymakers continue to fret, perhaps unduly, about the stickiness of inflationary pressures.

For now, this divergence in policy between major central banks is slight. The ECB’s rate cut was accompanied by hawkish language, with policymakers at pains to point out that the cut is not necessarily the start of a consistent downward trend.

And in the US, the Fed’s abundance of caution has been somewhat undermined by growing evidence that the US jobs market is beginning to cool. This is significant, because strong employment figures had been a key factor in the decision to leave rates unchanged. 

Nevertheless, the uncoupling of US and European monetary policy is real, at least for now. Despite its hawkish sentiment, economists currently expect two or three more rate cuts from the ECB this year. For its part, the Fed now thinks it will cut just once in 2024, and that possibly as late as December.

This is a fork in the road that could have important short- and long-term implications for the wider economy and global trade.

Europe gambles on growth

Europe is not out of the inflationary woods entirely. New forecasts suggest the ECB’s 2% target will only be reached later in 2025. Stickiness in wages and domestic inflation remain a worry. In an effort to manage expectations around rate cuts, policymakers insist there will be “bumps in the road”.

Nevertheless, the quarter point cut to interest rates is evidence of the central bank’s growing confidence in the longer-term inflation outlook, alongside a desire to stimulate sluggish economic growth in the Eurozone. While the real world impact of a quarter point cut is marginal, the psychological significance is important. The ECB is signalling a gradual shift in focus in favour of economic growth. Markets and businesses will not miss the hint.

By contrast, the Fed remains in a holding pattern. The resilience of the US economy has left many policymakers urging caution, despite an easing of price pressures in recent weeks.

The immediate impact of all this is likely to be a further strengthening of the dollar against the euro. That, in turn, could lead to an improvement in the Eurozone’s competitive position, giving a gentle boost to the region’s underwhelming economic outlook.

“Divergent monetary policies will make the US dollar more attractive compared to the euro, leading to an improvement of the eurozone’s competitive position versus the US,” says John Lorié, chief economist at Atradius. “A stronger US dollar relative to the euro could make Eurozone exports more competitive, potentially boosting trade while making US exports relatively more expensive on the global market.”

As the euro depreciates, countries might find euro-denominated goods cheaper, potentially shifting some trade flows towards Europe. This effect may be minimal at present, but is likely to gather momentum if monetary policy divergence becomes more pronounced through the year.

Monetary policy divergence: the new normal?

Which begs an obvious question: is monetary policy divergence likely to become more pronounced? Could a new normal see the ECB and Fed travelling consistently different monetary paths?

For much of the recent past, the ECB has tended to follow the Fed’s lead in monetary policy, often with a slight lag. Becoming the frontrunner in terms of interest rate easing is a break from recent historical norms.

It’s also something of a surprise. Six months ago, most economists were predicting a joint easing of monetary policy through 2024. As late as March, the Fed was talking about three interest rate cuts this year rather than one. But optimism over rate cuts quickly faded in the face of persistent inflationary pressures, including wage growth and - in the US - a remarkably resilient economy.

With more anaemic economic activity in the Eurozone, the ECB has decided that it can no longer wait for the Fed to act. A rate cut was heavily signalled in April and delivered in June. Any further easing will be based on local circumstances and inflation data, rather than any attempt at joint action with its US counterpart.

The impact of going it alone

This divergence means more independence of monetary policy between the Fed and ECB. This, as such, increases uncertainty and thus volatility in the financial markets, especially the currency markets. Businesses engaged in overseas trade should be aware of this. 

For example, faced with reduced competitiveness in global markets, US companies may need to reevaluate financing strategies and hedge `more against currency risks than before.

“There are also potential ripple effects on the wider trading environment,” says Lorié. “A stronger US dollar relative to the euro, for example, can affect the competitiveness of goods and services traded between the US and Europe. This can influence the terms of trade contracts between firms and bilateral trade balances". 

As the US dollar fluctuates more relative to the euro emerging economies, often with pegs to the US dollar, exporting to either or both might see swings in export volumes and revenues as well. Businesses involved in trade will need to be especially agile and should consider bolstering financial resilience to help navigate a volatile interest-rate environment. 

The only certainty is uncertainty

None of this is certain. The ECB’s way forward is by no means clear, and if the central bank identifies stronger inflationary trends, it may quickly fall into line with the Fed’s more cautious approach. By the same token, if US inflation indicators continue to improve, the Fed may feel empowered to take a more dovish stance on interest rate easing.

The room for manoeuvring of the ECB is limited anyway, as a large euro depreciation will have an upward effect on import prices and therefore inflation in the eurozone. This potential impact of an ECB rate cut restrains the rate cut as such.  

Having said that , businesses that engage in cross-border trade should prepare for the possibility of longer-term monetary policy divergence and the volatile US dollar exchange rate that would result. Credit insurance is one easy way to help maintain liquidity and financial stability in times of uncertainty. Increased vigilance is essential.

“By anticipating and responding to changing interest rate expectations and the resulting impact on currencies in the US and Europe, businesses can maintain a competitive edge in the global marketplace,” says Lorié. “A  divergence in monetary policy by the ECB and Fed creates  more uncertainty. Businesses need to prepare for that possibility.”