The European Central Bank started to raise its key interest rate after the US Federal Reserve kickstarted its rate hikes. The record-high inflation forced the regulators to make such a decision. The ECB is expected to increase the interest rate to 2.5% from 2.0% during its December meeting to curb the double-digit inflation in the region.
However, the markets are speculating about how long the ECB will continue rate hikes.
The EU inflation rate is higher than in the US. Moreover, it does not decelerate as much. Two months ago, everyone believed the ECB would have higher interest rates than the Federal Reserve in 2023.
Nevertheless, such expectations may prove to be wrong.
The US Federal Reserve and the European Central Bank steer their monetary policies in slightly different environments. Notably, the markets pay close attention to inflation but the regulators also closely monitor the labor market when making decisions. In this connection, there is a huge gap between the United States and the European Union.
The Fed has to combat inflation and deal with the overheated labor market at the same time. The US central bank managed to ease inflationary pressures but the labor market continues to raise woes. This fact leaves the regulator with insufficient room for action and rules out any reduction in the refinancing rate. At the same time, declining inflation is forcing the Fed to act more softly. The regulator is expected to moderate the pace of interest rate hikes. Meanwhile, it is likely to keep the rates high until unemployment starts to rise toward 5.0%.
In the EU, unemployment is considerably higher. As a rule, central banks stimulate job growth by lowering interest rates. However, rising inflation forces them to increase the rates. In other words, a 6.5% unemployment rate reduces the ECB's leverage for sharp rate hikes. Especially, when the unemployment rate is falling. If the refinancing rate is raised aggressively, the fragile employment growth is likely to be damaged. Therefore, one can hardly imagine that interest rates in Europe will be higher than in the US. The ECB may put brakes on the rate hikes before the Fed will do so.
Meanwhile, there is another burning issue.
In 2022, US President Joe Biden signed the Inflation Reduction Act. It includes direct subsidies for industries located in the US. The scale of the business support is so impressive that some major European industries have already openly announced that they are considering moving some of their production facilities from Europe to the US.
The European Union is already voicing concerns. France is stating that the United States has declared a trade war on the European Union with this act. The country urges other EU members to take appropriate countermeasures.
The problem is that the cost of energy in the European Union is several times higher than in the United States. This greatly affects the cost of production. Europe becomes less competitive. So, European companies have only two options left. They can either cut profits or cut costs by transferring production facilities out of Europe. Neither of these two options suits the largest EU countries.
In the context of the enormous debt burden of the European Union, it is possible to subsidize businesses on such a large scale only when interest rates are extremely low or even negative. In addition to direct budget subsidies financed by government borrowing, since there are no alternative sources of income, it is also possible to facilitate business crediting. However, this may come true only when interest rates are low.
In this relation, the ECB should consider lowering the refinancing rate rather than raising it. The European regulator may stop monetary policy tightening earlier than the Fed. Moreover, it may become the first regulator to start lowering interest rates. First of all, it needs to decrease inflation to appropriate levels. Notably, the central bank has already made some progress regarding this matter. Thus, in the middle of next year, the ECB is expected to gradually reduce the refinancing rate.
From the fundamental point of view, these facts may become a game changer, sending the EUR/USD pair to the parity level.
