After the biggest rise in the cost of living for a generation, the diverging paths of inflation in the Eurozone and the United States have prompted investors to predict the European Central Bank (the ECB) could cut interest rates earlier than the Federal Reserve (the Fed).—Financial Times, 3 April 2024.
What is the Eurozone?
The Eurozone (also called the Euro area) is a group of 19 countries that have adopted the euro as their currency. The ECB is the Eurozone’s central bank.
How is Eurozone inflation measured, and how high has it been?
Eurozone inflation is measured by the annual percentage change in a price index based on a fixed basket of consumer goods and services across the 19 countries of the Euro area called the Harmonized Index of Consumer Prices (HICP).
Eurozone core inflation is measured by the HICP excluding the prices of energy, food, alcohol, and tobacco.
Figure 1 shows these two measures of Eurozone inflation since 2020 during what the news clip calls “the biggest rise in the cost of living for a generation.”
The HICP inflation rate reached a peak of 10.6 percent per year in October 2022 and the core HICP peaked much later in March 2023 at 5.7 percent per year. After these peaks, Eurozone inflation fell rapidly. The inflation rate continued falling in 2024, but much more slowly than it fell during 2023.
How is U.S. inflation measured, and how high has it been?
U.S. inflation is measured using two price indexes.
The Consumer Price Index (CPI) is an average across U.S. cities of the prices paid by urban consumers for a fixed basket of consumer goods and services.
The Personal Consumption Expenditures Price Index (PCEPI) is an average of the prices of the items that make up the Personal Consumption Expenditures component of Gross Domestic Product. The weights on the items on PCEPI change as spending patterns in Gross Domestic Product change.
U.S. core inflation is measured by the CPI and PCEPI excluding the prices of food and energy.
Figure 2 shows these four measures of U.S. inflation starting in 2020.
The CPI inflation rate reached a peak of 9.0 percent per year in June 2022 and the core CPI peaked at 6.6 percent per year in September 2022.
The PCEPI inflation rate peaked at 7.1 percent per year in June 2022 and the core PCEPI peaked at 5.6 percent per year in February 2022.
Both the core U.S. inflation rates (both CPI and PCEPI) are falling in 2024, but the headline rates increased by 0.1 percentage points in February.
What were the “diverging paths of inflation in the Eurozone and the United States” in March 2024?
Figure 3 shows the headline inflation rates in the two economies, and Figure 4 show the core rates.
While it is true that the Eurozone inflation rate fell in February and March and the U.S. inflation rate increased slightly, Figure 3 shows no clear divergence between the two economies.
Figure 4 gives no information in the February and March data to indicate that Eurozone inflation is returning to target any faster than is U.S. inflation.
Why do investors try to predict interest rate changes?
Investors try to predict interest rate changes because a fall in the interest rate brings a rise in bond and stock prices—a capital gain. Similarly, a rise in the interest rate brings a fall in bond and stock prices—a capital loss. Investors who speculate try to buy before an interest rate falls and sell before an interest rate rises.
What would lead the ECB to cut interest rates earlier than the Fed?
Central banks are mandated to keep inflation close to 2 percent per year and, at the same time, keep the economy growing and close to full employment. When inflation is expected to rise, central banks raise interest rates to decrease demand and suppress inflation; when inflation is expected to fall, central banks lower interest rates to stimulate demand and avoid recession.
The ECB would cut interest rates earlier than the Fed if Eurozone inflation was expected to fall faster than U.S. inflation.
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