Does it matter if the ECB cuts rates before the Fed? No.


It is highly likely that this year the ECB will cut its policy rate before the Fed does. This sequencing has become a topic of debate amongst central bank watchers, as if the ECB would be jumping the queue and refuse to wait in line until the Fed has eased policy. Does it matter if the ECB cuts rates before the Fed? The answer is no.


At the start of the year, 2024 looked like the year of rate cuts in most advanced economies, Japan of course being the major exception. This view still holds, but it has evolved. It has been adapted based on the incoming data. We now think that the Federal Reserve will only cut rates at the December meeting or at the earliest in the autumn of this year.

And we also think that the ECB will ease policy to a smaller degree, a more limited degree than we were hoping earlier on this year.

Now the consequence of these forecasts, which are widely shared by economists, is that it looks like the ECB will cut before the Fed does. And this prospect has become hotly debated amongst economists, amongst central bank watchers. It is a matter of, does the sequencing raise economic issues?

Is the ECB going to jump the queue? Why is it not going to wait its turn to cut until the Federal Reserve would have done so? So, to the question whether it matters if the ECB cuts rates before the Federal Reserve, my view is that it does not matter. And this is what I will try to explain in this video. In assessing whether a rate cut is timely, premature, or overdue, what matters is whether the central bank acts according to its mandate. So we need to look at the inflation outlook and compare it to the inflation target of the central bank.

It's all about the policy reaction function that the central bank is using. Now, focusing on the European central bank, we know from past communication on many occasions that there are three key elements, factors, in that reaction function. One is the strength of monetary transmission. The second is what is happening in an underlying, in a kind of a longer-term trend in terms of inflation dynamics, or what has been happening to inflation dynamics. And thirdly, what is the outlook for inflation going forward.

When we look at these three factors, we can say that the European central bank has done a pretty good job. Look at the disinflation dynamics, which has been far better than in the U.S., by the way. But also look at the behavior of financial markets in this respect. It is interesting to note, as I have done in our recent publication EcoWeek, in which I have analyzed this topic in greater detail, it is interesting to note that the increase in U.S. treasury yields, which typically has a spillover effect into German bond yields, and that spillover effect has been more limited than what one would have expected based on the longer-term statistical relationship.

What it really shows is that markets are buying into the idea that, yes, there is now leeway for the ECB to start cutting rates. So, ECB is benefiting from credibility and, as a consequence, is benefiting from policy autonomy vis-à-vis the Federal Reserve.

There is still one question that needs to be answered, and that is, what about the euro? Indeed, should the ECB move ahead of the Federal Reserve? Isn't this going to trigger a significant decline in the euro, which would then have an upward pressure on import prices and triggering a jump in headline inflation?

To put it differently, should the concern about a possible euro weakening stop the ECB from moving before the Fed does? And in this respect, the answer is no. The reason is, firstly, that the desynchronization of the monetary policy cycle between the ECB and the Federal Reserve has already been largely priced in. It has been weeks and weeks since financial markets started to price the prospect that, indeed, based on economic fundamentals, based on inflation performance, the ECB should be able to move ahead of the Federal Reserve. And this has led to some moderate weakening of the euro already vis-à-vis the dollar. Now, the second point is that we should also keep in mind that the inflationary impact of a euro depreciation all in all is quite limited.

Research by the ECB a couple of years ago has shown that a 1% depreciation of the euro should eventually cause an increase of 0.04% of headline inflation. So, 1% depreciation of the currency, 0.04% increase in headline inflation. So, all in all, it is a very limited transmission.

As a consequence, the euro should not be a factor stopping the ECB to move ahead. And really what matters is what happens to the inflation outlook, of course. I thank you for having watched EcoTV and invite you to join us again soon.