US and Europe diverge on monetary policy as Trump scrambles outlook

The parting of the ways underscores mounting concerns about the embattled Eurozone economy, where policymakers fear further damage from a possible Trump-led trade war. The president-elect’s policy plans are expected to stoke US growth and inflation in the near term, with Fed chair Jay Powell stressing this month that he was in “no hurry” to lower interest rates.

Inflation and monetary policy moved in a broadly synchronised way across large parts of the world over the past three years as countries experienced a generational jump in price growth. But early moves to ease policy by the Fed, ECB, Bank of England and other western central banks this year could give way to a more discordant approach in 2025.

The yield on the US two-year Treasury — which closely tracks interest rate expectations — rose to 4.4 per cent at the end of the week from 3.6 per cent at the start of last month amid heightened concerns about inflation. 

The divergence has sparked a reversal in currency markets, where interest rates are a driving force. The dollar, which had been weakening since the summer, dramatically rallied against peers through the US election as investors anticipated the impact of Trump’s tariff and tax policies.

That has driven the euro to a near two-year low, in its biggest sell-off since the 2022 energy crisis, with the single currency further unsettled by weaker economic data that has pushed up the chance of a half-point rate cut by the ECB at next month’s meeting.

Samuel Tombs, economist at Pantheon Macroeconomics, said the US unemployment rate was still low enough and inflation expectations high enough “to suggest a renewed burst of inflation . . . becomes embedded.”

He added: “It is conceivable the Fed will have to end its easing cycle prematurely if Mr Trump implements his agenda quickly.”

Tom Barkin, president of the Richmond Fed and a voting member on this year’s policy-setting Federal Open Market Committee, told the Financial Times last week that returning rates to a more “neutral” level that no longer crimps growth “could happen quite slowly if you thought you needed to continue to lean against the inflationary breezes”.

Economists now expect US economic growth at 2.7 per cent in 2024, up from less than 1 per cent forecast in October 2023, according to Consensus Economics. For next year, economists revised their US economic growth forecasts to 1.9 per cent, up from 1.6 per cent expected in March. 

The trend is heading in the opposite direction in the Eurozone, where growth projections have been downgraded to 0.7 per cent this year and 1.1 per cent year. In the summer, economists expected growth of 1.4 per cent in the bloc for 2025. Some business surveys suggest that the Euro area economy could fall into recession, said McKeown at Capital Economics, “which would be a stark contrast with the resilience of the US economy”.

Markets are pricing in more than 1.5 percentage points of rate cuts by the end of next year for the ECB. This would take the deposit rate from the current 3.25 per cent to 2 per cent as early as June and below that by the end of the year. Economists polled by Consensus Economics expect a median rate of 2.15 per cent by December 2025.

In contrast, in the US, markets expect a less than 0.7 percentage points cut by the end of next year from the current rate of 4.5-4.75 per cent. Economists expect a median rate of 3.375 per cent. 

“The ECB’s focus is increasingly shifting to economic growth concerns, and away from inflation worries,” said Andrzej Szczepaniak, an economist at the investment bank Nomura. “Ultimately, we believe the ECB will be forced to cut rates to below neutral to support the economy.”

In the UK, markets expect gradual BoE rate cuts following the upward revisions to GDP growth and inflation as a result of the measures announced in the Autumn Budget.

UK economic growth has also been stronger than expected in the first half of the year, while inflation rose more than forecast to 2.3 per cent in October. Markets expect rates to fall to about 4 per cent by the end of next year from the current rate of 4.75 per cent.

Additional reporting by Olaf Storbeck in Frankfurt and Colby Smith in Washington