Interest Rate Cuts: Will the ECB Follow the FED or Perhaps the Other Way Around?

The European Central Bank (ECB) insists that it will not follow the moves of the U.S. Federal Reserve as it prepares for its first interest rate cut, but its future actions could still be shaped by what is happening in the U.S.

Trends driving the world’s largest economy typically do not take long to spill over into other regions, especially when it comes to financing and exchange rates, and then inflation, trade, and other economic indicators. For this reason, it is hard to expect that anyone can actually avoid the FED’s influence, at least when it comes to the fate of other economies.

For ECB officials gathering next week to discuss when, how quickly, and how much to pull back their aggressive monetary tightening, this means they are closely monitoring the U.S. – even as they emphasize that they will chart their own course.

– The ECB can absolutely go before the FED. Imagining that policies differ for a longer time – say nine months or more – is harder, as ultimately what drives decisions at the FED will spill over to Europe and affect the eurozone – said Piet Christiansen, chief strategist at Danske Bank, to Bloomberg.

Business Confidence is Rising

ECB policymakers led by President Christine Lagarde have begun preparing markets for an initial cut on June 6 as price pressures quickly ease. While they have strongly opposed the idea that they would want to stay in line with FED Chairman Jerome Powell, they have not committed to what will happen after the first step, claiming that economic data will decide.

Traders are betting that the ECB is most likely to implement four cuts this year, while they are divided on whether the FED will cut rates two or three times after Powell reiterated on Wednesday that he is in no rush to lower borrowing costs.

More than two years into Powell’s rate-hiking cycle, the U.S. economy has proven to be exceptionally resilient, with employers still hiring workers despite tough economic conditions. If this trend continues, such strength could also support the European economy, which narrowly avoided recession during the winter.

– As for inflation, it is too early to say whether recent readings represent anything more than a mere uptick. We do not expect it to be appropriate to lower our benchmark rate until we have more confidence that inflation is sustainably moving down towards two percent – Powell said on Wednesday in a speech at Stanford University in California.

Recent reports have shown signs of a nascent recovery in Europe, with purchasing managers seeing growth around the corner, and business confidence has also risen. Meanwhile, inflation in the euro area of 20 countries slowed more than expected in March and is approaching the ECB’s target at 2.4 percent.

Bloomberg Economics (BE) forecasts that price growth will slow to below two percent as early as August and average only 1.4 percent in 2025. The ECB’s own forecast is for a rate of two percent next year.

– Given that it was previously wrong about the breadth of cost pressures, the Governing Council will proceed cautiously as the easing cycle begins. But it remains reasonable to expect deep interest rate cuts this year – wrote Jamie Rush from BE in a note.

Investors Already Prepared for Losses in Euros

The ECB has previously proven that it can decouple from the FED. For example, when it cut rates in December 2015 and again in March 2016, the U.S. central bank began a three-year period of increases. The Swiss National Bank has already shown its path in the current cycle, unexpectedly lowering borrowing costs in March to prevent the franc’s appreciation.

Economists disagree on what the overall effect of the divergence between the ECB and the FED would be.

Some argue that more aggressive easing for the euro area could bring greater inflationary pressures, as lower borrowing costs compared to the U.S. could weaken the single currency and pose additional risks through higher import prices.

Former ECB chief economist Peter Praet, however, warns that a continuation of the FED’s tighter policy than expected could prompt policymakers in Frankfurt to cut rates more than they otherwise would.

– There is a real risk that rate cut expectations will be disappointed, resulting in tighter financial conditions globally. Ultimately, the ECB should not rule out the need for more aggressive rate cuts – he said.

Investors are already bracing for losses on the European currency. In the options market last week, there were twice as many contracts that were negative on the euro than positive, according to data from the Depository Trust & Clearing Corporation.

Some traders are betting that the currency will fall to $1.05, down from about $1.08 on Wednesday. Breaking that level could lead to the prospect of euro-dollar parity for the first time since 2022.

– The ECB will ‘outperform’ not only the FED but also most other G-10 central banks – said Valentin Marinov, head of G-10 FX strategy at Credit Agricole, to Bloomberg, citing weaker growth prospects for the bloc and easing inflation.

While ECB officials may be cautious about the currency’s decline, Lena Komileva, chief economist at G Plus Economics, argues that the eurozone may have to accept this.

– If the FED does not cut soon, then the ECB will have to cut and cut more than it otherwise would to avoid an unnecessary recession – Komileva believes.