ECB divergence: structural or transitory?

Eduardo García Castro, senior economist at MAPFRE Economics

At its last meeting, the European Central Bank (ECB) kept interest rates unchanged. It did, however, tease out the possibility of a first rate cut in June, in the expectation of by then having gained broader consensus from the members of its executive board. It also steered clear of committing to the subsequent sequence, not formally declaring victory over inflation or underpinning a consistent divergence from its US counterpart.

Therefore, a historically novel step forward is now expected, in that Europe has only made the first move ahead of the United States in this area three times before, which could highlight the importance of conducting an analysis of internal and external factors, even more so given the multipolar gap that continues to spread throughout the world, about which no extensive response was offered at the ECB’s most recent press conference.

The first divergence arose in the early 1970s, a stage that shares certain traits with the current one, given the delicate situation surrounding oil, conditioned by geopolitical fragmentation and where changes in the course taken between central banks exposed a president of the Federal Reserve (Alan Greenspan), who was unable to control the wave of first-order inflation, compared to the positive reaction of the Bundesbank, whose response to the episode further enhanced the German central bank’s good reputation.

The second situation presented itself at the end of the 1980s. The disengagement was linked to floating exchange rates and concerns about the decline in the German framework which had to deal with the sharp rise in interest rates decided on by then-President of the Federal Reserve, Paul Volcker, who was on a clear mission to tackle double-digit inflation that remained unresolved during the first wave of rising oil prices. At the opposite pole, the Bundesbank (among others) diverged by reducing interest rates and amplifying the strength of the US dollar, in a feedback process that ended up shaping the Plaza Accord, with the agreed depreciation of the dollar as a solution.

The last divergence took place during the recession of the early 1990s, with German reunification and the policy divergence that sought to address the rise in oil prices when Iraq invaded Kuwait. In 1991, the Federal Reserve, like the German Bundesbank, modified its interest rates, but in the opposite direction to previously. This discrepancy arose due to the German objective of curbing inflationary pressures that had intensified after the fall of the Berlin wall, which fed pressures not only on the dollar, but on the then ERM (European Exchange Rate Mechanism) system, a pressure that ended up triggering one of its most recent incorporations, the British pound.

Currently, the arguments in favor of the ECB going its own way regardless of the Federal Reserve are based on economic perspectives that remain weak against US resilience. However, a slowdown is already expected for the second half of the year after both central banks dodged the hard landing. Additionally, supply shocks that continue to reverse, at least under the hypothesis in place prior to the latest escalation of tensions in the Middle East must be considered, although the future tariff horizon is still unknown, as must the performance of the ECB's main objective. Inflation dynamics have been showing less peaks and valleys to date and are supported by both salary dynamics and expectations that are not driven by the risk of feeding second-round effects. It must be said that this risk perspective is open to being modified on the back of how oil and energy prices behave, should they be triggered again by geopolitical events, as history has shown us on previous occasions.

In short, the sum of arguments and counterarguments will take shape in June through the new projections of the ECB’s technical staff and will be presented as a more or less independent interest rate. For now, the internal balance seems to be tilting in the short term in favor of a decrease (more than 80% probability, according to current swaps). However, the sustainability of this course in the future, and the risk of disappointing the markets with fewer cuts, could be even more uncertain, at least as long as global dynamics continue to move in the same direction as they are today and central banks manage to remain on guard.