E.C.B. Is Likely to Leapfrog the Fed on Interest Rate Cuts

European Central Bank officials are expected to cut interest rates this week for the first time in more than five years, drawing a line under the worst of the eurozone’s inflation crisis and easing the pressure on the region’s weak economy.

But as policymakers in the eurozone move ahead, they leave behind their counterparts at the U.S. Federal Reserve, who are grappling with a seemingly more persistent inflation problem and warning that it will take longer to cut rates there.

Lowering interest rates in Europe before the United States does would create a gap between the policies of two of the world’s largest and most influential central banks. A move by the E.C.B. to ease its policy could weaken the euro, while higher interest rates in the United States would continue to tighten financial conditions there and in other countries because of the global role of the dollar.

Some analysts have questioned how far the E.C.B. can split from the Federal Reserve, while others say a divergence is not unusual and reflects two different economic situations.

“We are coming from more than a yearlong stagnation” in Europe with signs that disinflation is on track, said Mariano Cena, an economist at Barclays. “This is a very low starting point for an economy.”

By contrast, the U.S. economy has been booming over the past few quarters.

“There has already been divergence in the economies,” he said. “So if there is divergence in policy, it’s because it follows the different trajectories of the economies.”

Although the E.C.B. has stressed that it does not act based simply on what the Fed does, policymakers acknowledge that they cannot ignore the influence the Fed has on financial conditions and exchange rates all over the world.

“Monetary policy operates in a global context,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “If the global context changes because of the U.S., because of China, because of tariffs or whatever, then the E.C.B. has to take that into account.”

The E.C.B. has strongly telegraphed its intention to lower its key interest rate this Thursday, bringing it to 3.75 percent from 4 percent, the highest in the central bank’s history and where it has been since September. Inflation is predicted to sustainably return to the bank’s 2 percent target next year as the shock of high energy prices after Russia’s invasion of Ukraine fades.

The bloc’s inflation rate was 2.6 percent in May, slightly higher than the previous month, but it has slowed significantly from its peak, above 10 percent, in late 2022.

The eurozone economy is still reeling from the effects of the high interest rates that were put in place to combat high inflation. It grew a mere 0.3 percent in the first quarter of the year after five quarters of stagnation, the manufacturing sector is contracting, and there has been a substantial decline in demand for loans to expand businesses and buy homes.

But in the United States, Fed officials are finding it harder to tame the economy, where inflation has been driven by strong demand. The Consumer Price Index climbed 3.4 percent in April from a year earlier.

“What both regions have in common is that there is uncertainty” about the inflation outlook, Mr. Ducrozet said. But, he added, “the divergence case is still very strong.”

The E.C.B. and the Fed have diverged in the past, such as in the years before and after the 2008 financial crisis. In 2014, as Europe struggled with deflation and the region’s sovereign debt crisis, the gap grew for another five years as the E.C.B. introduced negative interest rates and a large bond-buying program.

This time, the divergence is expected to last only as long as it takes the Fed to start cutting rates. The two central banks are not expected to move in opposite directions, especially after a measure of U.S. inflation in April provided some welcome signals of modest cooling in prices and consumer spending.

That would quell one of the biggest concerns investors have about the E.C.B.’s moving ahead of the Fed: that the euro could weaken against the U.S. dollar and the region would import inflation through its exchange rate. If the E.C.B. delivers what traders anticipate, the exchange rate should not move much, Mr. Cena said.

The E.C.B. is expected to deliver only a few rate cuts this year, just a quarter-point reduction once a quarter, which would still restrict the economy. There’s justification for the cautious approach: Inflation in the eurozone’s services sector, a stubborn category heavily influenced by wages, accelerated to 4.1 percent in May, from 3.7 percent the previous month.

“That is something that raised eyebrows,” said Jumana Saleheen, chief European economist at Vanguard.

Services inflation is not showing much sign of slowing. “It’s worrying but not alarming,” said Ms. Saleheen, who added that the other components of inflation, such as food and goods, had slowed substantially. She expects the E.C.B. to cut rates three times this year.

“In general, it’s good news,” she said. “In Europe, the worst is over, we’ve ended stagnation and we’re now moving to a period where we can return to trend growth.”

Still, analysts say there are limits to how far the E.C.B. could go without the Fed.

“The longer you postpone Fed cuts, the more difficult it can be eventually for the E.C.B.,” Mr. Ducrozet said, adding that the situation would become harder “if the Fed doesn’t cut at all or — worse — if they start to be really concerned that the election will lead to another inflationary wave of pressure.”

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