Emerging policy differences will force looser monetary policy in Europe than in the US.
Imagine two typical middle-class consumers, one in the US and one in Europe. Both are thinking about buying a car and are reasonably informed about the news.
In the US, everything screams buy, buy buy. Donald Trump might have shied away from steep tariffs on Canada and Mexico, but the reprieve was temporary. Whether you believe that tariffs would raise prices or not, why risk it?
In Europe, real incomes are rising but the mood is sour. Trump is making threats to harm the EU economy and his words will make car manufacturers, whether European or Chinese, keener to sell. Waiting a bit longer before taking the plunge makes sense.
These considerations are fictional. But we already see this sentiment in economic data. At current interest rates, you cannot get Americans out of the shops and you cannot persuade Europeans to spend.
The cyclical strength of US consumers is matched by its corporates, who have increased investment far above pre-Covid levels. According to Citi, in the third quarter of last year, non-residential investment was 17 per cent higher than on the eve of the pandemic in the US, while it was 8 per cent higher in the UK and a little over 8 per cent lower in the Eurozone. Britain was doing better than its continental neighbour but much of that reflects some recovery after a terrible period for business investment following the 2016 Brexit referendum.
Partly, these trends reflect the difference in shocks Europe and the US have faced since Covid, with a more intense energy shock in Europe and the need to decrease its dependence on Russian oil and gas. They also reflect worse underlying recovery of productivity following the pandemic — especially in northern Europe. And the same patterns have shown up in weak consumer and business confidence.
Almost all the international trends suggest the economic cycle is markedly different on either side of the Atlantic; interest rates should correspondingly diverge significantly for the first time since the global financial crisis of 2008-09. Rates are restricting activity more in Europe than in the US where animal spirits are higher.
Europe needs looser monetary policy and Trump’s policy changes amplify the necessary divergence. The new US administration is likely to offer lower taxes, while making quite a show of tiny spending cuts in some specific grants to federal organisations and foreign aid. In contrast, budgetary policy is tightening in Europe, with a sharp fiscal consolidation planned in the UK this year.
If Trump imposes significant increases in tariffs on the EU, as he has threatened, this will act as a negative supply shock in the US making it harder for the Federal Reserve to cut interest rates. So long as Europe chooses its retaliation judiciously, the effect will be more of a demand shock, requiring looser policies.
While the economic forces and policy divergence suggest the need for significant decoupling of short and longer term interest rates, financial markets so far have moved roughly in sync. Longer term government borrowing costs have risen everywhere since September (albeit with a gap opening up between the French and German 10-year yields and those in the US).
This gap is likely to widen, especially in the UK where borrowing costs have not decoupled from the US nearly as much as those in the Eurozone. That is mostly due to the Bank of England showing more caution in cutting rates than either the Fed or the European Central Bank so far.
Most important, though, when the US has ceded its international leadership in economics, is for Europe as a whole to demonstrate that its policies are not subtly driven by America. That requires both governments and central banks to declare their independence from the US while seeking to maintain as close trading links as Trump will tolerate.
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