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Europe’s Economic Divergence With US is Real but Has Its Limits

Inflation in the euro zone is different to that in the United States, much as ECB President Christine Lagarde insists, but the bloc will still face many of the same headwinds as others, limiting how far price growth can slow.

The ECB put an interest rate cut in June on the table on Thursday, arguing that price growth was decelerating towards 2% and the 20-nation bloc was “not the same” as the U.S., which is struggling with unexpectedly stubborn inflation that may delay interest rate cuts there.

While numerous differences underscore Lagarde’s point, Europe does not exist in a vacuum and problems in the U.S. are bound to make their way across the Atlantic, albeit over time and in a more muted form, economists say.

Two fresh surveys by the ECB published on Friday reveal the contrast – one suggesting euro zone growth will be barely above zero this year, and another showing the bloc’s biggest firms see contracting investments, workforce cuts and poor retail sales.

This is pushing the long expected recovery further and further out, and even if the economy seems to have bottomed out, the tentative signs of demand and sentiment recovery point only to a gradual and muted rebound.

Annualised growth in the U.S., meanwhile, was above 3% in the final quarter of 2023 and inflation was driven primarily by demand.

“We remain convinced that, given wildly different demand/consumption backdrops in the euro area and U.S., U.S. demand-driven inflation can sustainably diverge from mostly supply-driven euro area inflation,” TS Lombard’s Davide Oneglia said.


In contrast, U.S. consumer demand remains so strong that any fresh import has better pricing power.

Fiscal policy is another key factor in the divergence. While the U.S. government could run a budget deficit of 5.6% of GDP this year with a further increase in 2025, the fiscal impulse in the euro zone is shrinking, with the budget deficit seen down at 2.9% this year before another drop in 2025.

The labour market is also crucial. Euro zone unemployment may be at a historic low, but broader measures of slack which also count underemployment stand at around 11% versus just above 7% in the U.S.

More importantly, while much of the euro zone’s high employment is a factor of labour hoarding by firms who fear a loss of skilled workers, the U.S. continues to create new jobs much faster than expected.

High interest rates also tend to feed into U.S. housing costs much quicker than in Europe, a key reason why “shelter” inflation is above 5%.


Still, Europe will suffer commodity price increases much like everybody else or possibly even more given that it is a net importer.

Energy has been the biggest drag on inflation this year, but crude oil is up 14% since the start of 2024 and this will start adding to prices in the second half of the year, even as natural gas prices hold broadly steady.

In addition, expectations of faster euro zone rate cuts have already weakened the euro, and this raises the prices of imported goods, thereby lifting consumer prices.

Weakening labour productivity could also add to Europe’s inflation since it means greater unit labour costs that must eventually find their way into consumer prices.

“We disagree with what Christine Lagarde said regarding U.S. inflation and the full decoupling of euro zone inflation developments from those in the U.S.,” ING economist Carsten Brzeski said.

“Headline inflation developments in the U.S. have nicely led euro zone developments with a lag of around half a year; not necessarily the exact monthly inflation numbers, but definitely the broader direction of inflation.”

Nevertheless, the divergence is clear and the ECB will be able to lower interest rates before the Fed, even if it will be buffeted by the same headwinds, limiting its ability to go it alone.

“Given the relative data flow — slower growth, lower inflation, tighter fiscal policy — the ECB has the basis to act independently of the Fed and ease in June and maybe several times this year,” Deutsche Bank said.

“However, there are likely to be limits to the ECB’s independence from the Fed over time to the extent that the euro area and U.S. are large trading partners of one another.”

Source: Reuters