Interview
Central bank divergence: Why it's happening and why it matters
- The European Central Bank is expected to begin cutting its policy rate this week, with current market pricing indicating approximately 75 basis points of cuts for the year, a figure the ECB views as comfortable; conversely, the Federal Reserve is expected to remain on hold at its upcoming meeting, with the U.S. market pricing only zero to two cuts, a divergence that may sustain a stronger dollar for an extended period.
- Disinflation trends are materializing across G10 economies, with year-on-year CPI and PCE rates declining, though the pace has been slower than initially anticipated at the start of the year; the U.S. experienced a quicker inflation upturn and downturn than peers but has recently stalled or regressed slightly, while Europe and Canada face strong economic cases for easing due to softening growth and falling inflation, whereas the UK presents a more complex picture due to lagging disinflation relative to the weakened labor market.
- The U.S. economy remains relatively stronger than other G10 counterparts but is showing signs of marginal softening, with first-half GDP growth projected in the low to mid-two percent range compared to the four percent seen in the second half of the previous year, alongside declining job growth and rising unemployment that signal labor market loosening.
- Structural factors in the U.S. include a productivity growth trend of 1.5 percent, which aligns with pre-pandemic levels, and a substantial influx of immigrants boosting labor supply, resulting in a modest rise in the unemployment rate despite a significant narrowing of the jobs-workers gap.
- Significant divergence in monetary policy paths is anticipated, particularly if the Fed holds rates while the ECB, Bank of England, and other central banks cut; this divergence could drive portfolio reallocations toward the U.S., potentially lowering long-term rates, though excessive policy splits could derail European recovery and cause wild currency reactions.
- Currency dynamics are influenced by the expectation that higher U.S. rates will keep the dollar strong, with room for further appreciation beyond fall 2022 levels, although limits to a stronger dollar may eventually arise from export or import-competing industries seeking protection, though an official response similar to the 1985 Plaza Agreement is deemed unlikely due to low international cooperation.
- Market uncertainty is heightened by the U.S. presidential election, potential shifts in expansionary fiscal policy, and the prospect of a change in administration, which could significantly alter the trajectory of a stronger dollar and the management of macroeconomic divergences.
- The Bank of Japan is facing distinct pressures, with the yen's weakness raising inflation concerns and prompting a slow, cautious approach to rate hikes from very low levels, creating a divergence from other major central banks that are more aggressively considering or implementing easing.
- Risks include the possibility that premature rate cut signals from the Federal Reserve in late last year loosened financial conditions too much, leading to higher sequential inflation numbers and a perception that market expectations for European cuts may have been too aggressive given that the disinflationary process is not yet finalized.
- While central banks generally synchronize policy despite differing inflation sources (supply-driven in Europe versus demand-driven in the U.S.), there is scope for managed divergence; however, if the Fed moves in a more hawkish direction, it will constrain the extent to which the ECB can ease policy, and currencies for nations cutting rates while the Fed holds steady are likely to depreciate, though the ECB is less concerned about this due to the Euro area's external closure.