How the price of your fill-up is also determined in Washington

Call it a luxury problem. The US central bank, the Federal Reserve, has revised its plans. Not because the American economy is in bad shape, but rather because it is doing too well. Growth remains healthy, consumers are spending money and unemployment remains low. That also keeps inflation high, and so the Fed has changed course: contrary to previously thought, interest rates cannot be lowered for the time being.

We should not expect a rapid reduction, Fed Chairman Jerome Powell suggested on Wednesday during a press conference on monetary policy. “If inflation remains at this level, we will have to put that plan on hold for the time being.”

The European Central Bank (ECB), on the other hand, has indicated that European interest rates will indeed fall in June. Vice-President Luis De Guindos called this a “fait accompli” last month. Powell and ECB President Christine Lagarde are therefore heading in different directions. While the Fed no longer explicitly refers to a rapid interest rate cut in its official policy statement, the ECB has introduced that possibility.

That is not completely illogical. The economies on either side of the Atlantic Ocean look very different. While prosperity in the United States is growing by 1.6 percent per year, in the eurozone it is 0.4 percent. In the United States, 3.8 percent of the workforce is unemployed, in the eurozone 6.5 percent. Inflation in the US is considerably higher than in the eurozone: 3.5 percent compared to 2.4 percent. That is why the Fed keeps interest rates at 5.25 percent, while the ECB is now at 4 percent.

Eurozone deviates

Moreover, the cause of inflation is different in the two regions, explains Peter Vanden Houte, ING Belgium’s chief economist. “In short, the eurozone experienced a supply shock and the US experienced a demand shock,” he says. In Europe, prices rose because the supply of energy and raw materials faltered, in the US because the economic recovery after the pandemic exceeded the economy’s production capacity.

The so-called divergence between the two economic blocs is an important theme among market watchers. After all, there are implications for the financial markets. “Eyebrows are being raised, because the ECB usually follows that of the Fed with some delay,” the chief economist of US asset manager Vanguard noted last week. “But the circumstances in the eurozone are now so divergent that they justify a divergent policy.”

More expensive to refuel

“An effect on the exchange rate is the most obvious,” says Vanden Houte. Higher US interest rates could undermine the value of the euro, because large investors will opt for investments in dollars instead of euros. A weak euro means admittedly tailwind for exporting companies, but also higher energy costs. This can make refueling more expensive. This could spark inflation again. That does not make the ECB’s task any easier. Nevertheless, an interest rate cut in June is defensible, Vanden Houte believes. “The extent to which prices are now rising on a monthly basis suggests that inflation is returning to levels below 2 percent.”

A plausible scenario is that interest rates are slightly reduced at the end of the year in both the US and Europe, but that the Fed makes the decision a little later than the ECB. “The ECB is aware of the situation,” says Vanden Houte. This is evident from the communications of various bankers. While it was initially thought that the June interest rate decision would be the start of a longer series of cuts, this is now less certain.