Fed Maintains Cautious Stance as ECB Prepares for Easing

Inflation Concerns Keep Fed Cautious, ECB Eyes Rate Cuts

by Faruk Imamovic
SHARE
Fed Maintains Cautious Stance as ECB Prepares for Easing
© Getty Images/Alex Wong

As US traders return to their desks after the Memorial Day holiday, they find the economic landscape dominated by discussions on inflation and interest rates. The Federal Reserve (Fed) maintains a cautious outlook on rate cuts, despite expectations that US inflation will ease in the coming months, driven primarily by a reduction in rent prices. The Fed's June projections might show an increase in the median long-term interest rate, reflecting concerns about supply-side constraints in the coming years.

In contrast, the European Central Bank (ECB) is showing less caution regarding the prospect of easing monetary policy. The ECB cites declining survey-based inflation expectations and a slowdown in wage inflation as justifications for potentially starting to ease in June.

Stock Market Influences and Inflationary Pressures

US stock index futures, led by the Nasdaq 100, are on the rise, boosted by a report from China's Academy of Information and Communications Technology, which noted a significant increase in smartphone shipments in March and April. This news has positively impacted Apple's stock and the broader technology sector. The tech rally, which began with Nvidia's impressive Q1 earnings announcement, has significantly bolstered US household wealth, equivalent to about 10% of annual US GDP.

This surge in wealth is likely to increase consumer spending, adding to inflationary pressures. While the AI revolution promises long-term productivity gains, the immediate effect is inflationary, as households tend to spend more before these gains are realized. Consequently, Fed policymakers might view the stock market rally as a reason to delay rate cuts.

Two participants at the Fed's May 1 policy meeting noted that "financial conditions appeared favorable for wealthier households, which account for a large portion of aggregate consumption, with hefty wealth gains resulting from recent equity and house price increases." The Minneapolis Fed's Neel Kashkari echoed this sentiment, stating that the Fed should be patient in monitoring inflation trends before considering interest-rate cuts, especially given the US economy's remarkable resilience.

Long-term Supply-side Constraints

The Fed's concerns are not limited to short-term inflationary pressures. The central bank is also focused on long-term supply-side constraints, including de-globalization, climate change, decarbonization, demographic transitions, and global conflicts. These factors are likely to influence the debate around the neutral interest rate (R*), the real equilibrium rate of interest that policy rates should converge toward as the Fed achieves its 2% inflation target. It seems inevitable that the Fed will raise its R* estimates to account for these supply-side challenges.

Divergent Central Bank Policies

For the US dollar (USD), the divergence in central bank policies plays a crucial role. The resilience of the US economy, coupled with a cautious Fed, contrasts sharply with the ECB's more aggressive stance on easing. ECB Governing Council member Francois Villeroy has even suggested the possibility of a follow-up rate cut as early as July, although the more hawkish Philip Lane prefers a "data-dependent" and "meeting by meeting" approach.

The impetus for a rate cut by the ECB is bolstered by the ongoing decline in Euro area inflation expectations. The ECB's April consumer survey revealed that expectations for Euro area inflation over the next 12 months fell to 2.9%, the lowest since September 2021, down from 3.0% in March. Similarly, inflation expectations over three years edged down to 2.4% from 2.5% in March. Despite some uncertainties about wage disinflation, third-party wage growth trackers indicate that wage disinflation in the Euro area continues at a pace (3% annualized) lower than in the US (4.0%).

Upcoming Treasury Auctions

The US Treasury's upcoming auctions of new 2-year and 5-year notes could face weak demand if traders remain cautious following the hawkish tone from the Federal Open Market Committee (FOMC) minutes last week or in anticipation of more hawkish Fed commentary this week. This cautious sentiment among traders underscores the broader uncertainty and careful navigation required in the current economic environment.

SHARE