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Why the divergence between US and European inflation has reversed

芊芊551
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Financial markets have grown accustomed to higher inflation and interest rates in the United States than in Europe. Now they may need to change their minds. Not only is inflation in the US now lower than in the eurozone, but it may remain so in the future.
This could cause bond market spreads to narrow or even reverse, and the euro could continue to fall against the dollar.
From the early 2000s through 2019, consumer price inflation in the United States averaged 2.2 percent. Inflation in the eurozone and Germany is much lower, at 1.7% and 1.5% respectively.
After peaking in 2022, US inflation fell to 3.7 per cent in August. By contrast, inflation in the eurozone is still 5.2% and in Germany 6.2%. Us core inflation, which excludes food and energy prices, is also lower.
There are three reasons why inflation will also be lower on the other side of the Atlantic in the future.
First, to fight inflation, the Fed has been more determined than the European Central Bank to raise rates. In September America's benchmark interest rate was 1.8 percentage points above inflation, while the euro area's was 1.2 percentage points below it. Although the European Central Bank raised its key interest rate again at its latest meeting, it sent a signal to the market that it may have reached its peak. The Federal Reserve recently left its benchmark interest rate unchanged but said it was on track to raise it further.
Second, the Fed has so far reduced its holdings of bonds purchased to increase the money supply by about 12 per cent. By contrast, the European Central Bank has reduced its holdings by just 6 per cent.
The pace of future bond sales by the ECB is also likely to slow. In its 1.7 trillion euro pandemic plan, the ECB wants to replace maturing bonds with new purchases by the end of 2024 to keep interest rates low for the euro zone's heavily indebted countries.
Third, structural inflation in the eurozone is likely to remain higher than in the US because of expensive commodity imports, higher prices for carbon allowances, and rising wages due to Labour shortages.
In the past, high inflation in the US has been associated with high interest rates. For example, ten-year US government bonds issued between 2000 and 2019 yielded an average annual yield of 3.4%, while the corresponding German bunds yielded only 2.6%.
Today, US Treasuries yield 4.6 per cent and German Bunds 2.8 per cent. Once markets adjust to the reversal in inflation differentials, German Bund yields could rise to or exceed US levels.
That would be hard for eurozone politicians to accept. As a result, the pressure on the ECB to keep rates low will increase further.
If the ECB caved in, the combination of high inflation and low interest rates would cause the euro to depreciate against the dollar.
The euro has appreciated 10% against the dollar since its last low in September 2022. However, the euro has lost 31 per cent of its value against the dollar since its record high in March 2008.
The euro's decline is likely to continue as markets adjust to the reversal of the inflation divergence between the eurozone and the US, and as politicians in the eurozone's heavily indebted countries block the ECB from effectively fighting inflation.
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