Oct 23 2024: Despite the differing economic and inflationary outlooks for the U.S. and Europe, interest rates in both regions have followed similar paths this year. Money markets expect this trend to continue, but economic reasoning suggests otherwise.
Currently, the Federal Reserve (Fed), Bank of England (BoE), and European Central Bank (ECB) are all expected to implement almost identical levels of policy easing through 2025, with markets pricing in 135 basis points (bps) of cuts for the Fed, 134 bps for the BoE, and 133 bps for the ECB.
While the ECB and Fed started easing earlier than the BoE, the near-identical projections for all three central banks are inconsistent with the economic realities in each region.
Decoupling Ahead for Fed and ECB
The biggest divergence is likely between the Fed and ECB. While the Fed may reduce its policy easing over the next year due to the U.S. economy’s surprising strength, the ECB may have to ease more aggressively than markets currently anticipate.
The U.S. economy remains resilient, with growth tracking above 3%, upward GDP revisions, and a strong labor market. While the Fed may cut rates by up to 150 bps by the end of next year if inflation cools, there’s a high chance that the rate-cutting cycle could be shallower, with the terminal rate possibly nearing 4%.
In contrast, euro-zone inflation is already below the ECB’s 2% target, and Germany is teetering on the edge of a second consecutive annual GDP contraction. Many economists believe that the ECB will need to cut rates more sharply than currently priced, potentially by 50 bps per meeting in 2024.
R-Stars and Lower Terminal Rates
Economists at global banks like Nomura and Morgan Stanley suggest that the ECB’s nominal neutral rate could fall to as low as 1.0-1.4%, far below its current policy rate of 3.25%. This projection incorporates the euro-zone’s 2% inflation target and estimates of “R-star,” the neutral rate that neither stimulates nor restricts economic growth, which is currently seen in negative territory.
A slower approach to this lower terminal rate may occur, but the longer inflation and growth remain subdued in Europe, the more current market expectations will appear overly optimistic.
Implications for the BoE and Market Sentiment
Britain’s economic dynamics are not as weak as the euro-zone’s, but it is puzzling that markets expect the BoE to ease as much as the Fed through 2025, given the U.S.’s stronger fundamentals. Goldman Sachs analysts suggest the U.K.’s nominal neutral rate sits around 2.75%, indicating that the BoE may need to cut rates more sharply than markets currently anticipate.
If U.S. rates fall significantly less than those in Europe, the consensus view that the dollar will weaken in the coming year could be wrong. This would provide the greenback with more room to strengthen, which may actually benefit the euro-zone by weakening the euro, thus boosting exports and lifting inflation slightly.
In the near term, the rate alignment between the U.S., U.K., and Europe may persist due to the uncertainty surrounding the U.S. presidential election. However, once this uncertainty dissipates, a divergence in rate paths appears inevitable.
