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Will the ECB drag the Fed along

At the beginning of June, the European Central Bank began to lower its key rates, without waiting for a move from its American counterpart, the Fed. Is Europe in the process of emancipating itself from American monetary policy or, on the contrary, can it set the tone in this area? Christian de Boissieu explains why such a scenario is not likely.

Thus, on June 12, the Fed unanimously decided by the members of its Monetary Policy Committee (FOMC) not to touch its key rate, the interest rate on federal funds, maintained in the %-5,50% range. The US central bank justifies its caution with several arguments: inflation, gross but also excluding volatile components (agricultural and energy prices), as well as inflation expectations still remain significantly above the 2% per year target; Growth remains strong (forecast for this year close to 3%), as does the labour market.

Wait and see! Now, the first cut in the key rate is expected in September, and the futures markets, which are not necessarily right, are anticipating a total of two cuts by the end of 2024, less than expected just a few weeks ago. The Fed is pragmatic, it does not want to tie its hands given the degree of uncertainty. Forward guidance of rates, which was at the heart of unconventional monetary policy, has now been forgotten on both sides of the Atlantic. And the Fed insists on the continuation of its sales of part of its bond portfolio, and therefore on the reduction of its balance sheet.

No ripple effect on the Fed

We can therefore see that the start of the ECB’s 25 basis point cut in its key rates on 6 June (the deposit facility rate rose from 4% to 3.75%) has not caused any knock-on effect on the Fed. Even before we saw it, we could have suspected it given the asymmetries in favour of the United States and the dollar. US monetary policy is not lagging behind monetary decisions taken abroad! What is new in this case is the symmetrical side. It is that the ECB has let its guard down without waiting for a prior initiative on the American side.

For years, and for both upward and downward movements, the ECB has most often acted after the Fed. With a significant delay that has frequently been criticized. For example, after the subprime crisis and the bankruptcy of Lehman Brothers, the ECB took a long time to implement a key rate close to zero.

A low-pressure zone

Where does the ECB’s current boldness come from, and what will be the foreseeable consequences and consequences? Despite globalization and the multiple interdependencies it engenders, the American economic cycle and the European cycle do not coincide. As we have seen, growth rates, inflation rates, unemployment rates… are different. As Europe remains generally speaking an area of “low pressure”, i.e. poor growth and productivity performance compared to the United States, the ECB can make its contribution to the revival of activity provided that its main objective – price stability – is not threatened. It considered that this condition had been met thanks to the disinflation that is beginning, even if it acknowledged that the evolution of inflation in the coming months is likely to “bump”.

The significantly positive gap between the Fed’s and the ECB’s key rates has therefore widened since the ECB’s initiative of 6 June. So what? Three remarks. This spread could return to the level before June 6 if the Fed starts its cut in September. The ECB could cut its key rates again in the autumn, but the Fed would probably be in the same tempo… Not out of a desire to stick closely to the ECB’s decisions, but for purely American reasons. Secondly, all this only indirectly and partially regulates movements in long-term rates. Given the weight of the US financial markets, the causality continues to shift from US to European long rates, and not the other way around. And the spreads between long-term rates within the euro area are now more sensitive to the European and French elections than to other influences (see the widening of France’s spreads).

Finally, we cannot omit the exchange rate argument. The ECB’s unilateral initiative could have pushed the euro back against the dollar, and in doing so accentuated inflation in the euro zone through the increase in the cost of imports. This was feared by Robert Holzmann, the governor of the central bank of Austria, the only one to have voted against the June 6 decision at the ECB. In practice, the euro has since fallen slightly, more as a result of the results of the European elections than as a result of the widening of the policy rate differential on both sides of the Atlantic.

A long-term wait-and-see Fed

Clearly, this differential would have to widen significantly, in which case the ECB would be much more reactive in the direction of easing rates than the Fed, for an exchange rate effect, i.e. a significant decline in the euro, to appear.

This is not the most likely scenario between now and the end of 2024: the Fed will not remain in a wait-and-see attitude for long. It will gradually loosen the monetary constraint, not because of the ECB’s initiatives but for reasons of its own. On the American side, the doctrine of “benign neglect” with regard to the exchange rate of the dollar, at least in a wide range of values for this rate, is far from having disappeared!

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