Europe shouldn’t cut rates before the U.S. – This is why

Europe is on the verge of making a major move in its monetary policy, but this time, it might just be stepping out too soon, especially before the U.S. does. Christine Lagarde, the president of the European Central Bank (ECB), hinted last month that the ECB might begin slashing rates sooner than the U.S. Federal Reserve. She made it clear that unless there’s a big upset, the ECB is set to ease off on its tight policy.

Hasty Decisions May Lead to Risky Waters

The ECB, not wanting to ride on the Fed’s coattails, is charting its own course. Investors are all in, expecting a reduction in the ECB’s deposit rate, currently at a steep 4%, possibly as early as next month. They’re even betting on two more cuts later this year.

Contrast this with the strategy over at the Fed, where the plan is to keep rates up longer, with a possible rate cut in late 2023. Jay Powell, the Fed Chair, mentioned last week it might take a while before they’re confident that inflation has settled down to 2%.

Europe’s economy isn’t exactly booming, with GDP growth lagging and a slow disinflation process that aligns with what the ECB projected. Yet, if the ECB cuts rates too far off from the Fed’s timeline, it could ignite problems for both growth and inflation in the region.

Remember, Europe has jumped the gun on rate cuts before, like back in 1999 and 2011, but today’s scenario is far different and possibly more precarious.

For starters, cutting rates might weaken the euro, which could mean higher prices for imported goods. This is especially troubling considering Europe’s heavy reliance on imported energy.

About two-thirds of its energy is imported, compared to just 21% for China, and unlike the U.S., which produces more energy than it uses. A rise in energy costs could hurt business investments, offsetting any positive bounce from the rate cut.

Market Perception and Economic Forecast

Another risk is market perception. A premature rate cut could signal that the ECB expects weak economic performance, possibly dampening private sector confidence and investment. The Eurozone’s economy is already not the best performer, with growth at a mere 0.3% this quarter, just a tad below the U.S. at 0.4%.

The credibility of the ECB could take a hit if it moves too quickly. If the Fed holds off on adjusting its rates, the ECB could find itself under pressure to halt its rate cuts, shaking long-term confidence in its monetary decisions. The stability of both inflation and GDP growth could become more unpredictable, influenced heavily by the ECB’s actions.

In contrast, fiscal measures could offer a more stable remedy to the region’s economic woes. Europe has about €800 billion in untapped funds from the Next Generation EU recovery program. If used wisely, this could bolster investment far more effectively than rate adjustments.

As of now, only a third of these funds have been handed out. Tax incentives for investments could also help in improving productivity without the risks associated with aggressive monetary easing.

Meanwhile, the ECB predicts that inflation will gradually move toward the 2% target over the next few quarters, and economic output in the Eurozone is expected to outpace previous forecasts. Growth projections for major economies like Germany have been revised upward, indicating a potential recovery from stagnation.

Despite these optimistic signs, the ECB’s eagerness to cut rates could be premature. A balanced approach, favoring neither excessive haste nor undue delay, would serve Europe best