Solo-minded ECB may find itself singing from Fed’s hymn sheet after all

The European Central Bank may protest it is not “Fed-dependent” but it will likely find itself singing from a hymn sheet largely written by the U.S. Federal Reserve whether it wants to or not.

The ECB is sticking to plans to reduce interest rates from record highs, likely at its next meeting in June, in light of a continued fall in inflation in the 20 countries that share the euro.

This is in contrast to U.S. price growth, which has beaten analyst expectations for three months straight, and is now expected to keep the Fed from lowering its own borrowing costs until September.

ECB President Christine Lagarde insisted her institution was “data-dependent, not Fed-dependent” on Thursday. But analysts and policymakers said high U.S. inflation and interest rates were bound to have an impact on the ECB’s plans via financial markets and trade.

“While we continue to believe that the ECB will be the first central bank to start cutting rates this year, the path beyond that will remain dictated by Fed action,” Max Stainton, a senior global macro strategist at Fidelity International, said.

In a sign of how closely interrelated central banks are at present, Sweden’s Riksbank said on Thursday the main threat to a May interest rate cut would come from the postponement of the Fed’s and the ECB’s own easing cycles.

Sources told Reuters after Thursday’s meeting that ECB policymakers still expected to cut interest rates in June but some thought the case for pausing at their following meeting was becoming stronger given U.S. inflation.

They argue the euro zone’s central bank could skip a mid-summer rate reduction until it was comfortable with the path for U.S. borrowing costs.

EXCHANGE RATE
This is because lower interest rates in the euro zone than in the United States were bound to depress the euro’s exchange rate, mechanically increasing the price of some goods priced in U.S. dollars, such as crude oil.

This has already started to happen, with the euro down 1.3% against the U.S. dollar since the U.S. inflation reading on Wednesday to the lowest level since February. FRX/

“We continue to think that the ECB will likely end up cutting rates ahead of the Fed, although the number of cuts will be restrained somewhat by the currency effect via a vis dollar,” Andrew Lake, head of fixed income at Mirabaud Asset Management, said.

Money markets price in three interest rate cuts by the ECB by December versus four only a few weeks ago.

In addition, U.S. inflation has led that of the euro zone by a few months in this last cycle with surprising precision.
While the reason for the price increases might have been different – with demand in the United States playing a much stronger role than in the euro zone, where higher fuel costs were the key driver – some still see scope for contagion given the regions’ close financial and trade ties.

“The ECB is independent of the Fed,” Mohit Kumar, chief European economist at Jefferies, said. “But the Fed is also data dependent and if U.S. data continues to be strong, it may have an impact on European data as well.”

Some analysts cautioned the impact might be more mixed.

The euro zone’s own bond yields were likely to rise in tandem with their U.S. counterparts, tightening financial conditions and perhaps even requiring the ECB to cut its own interest rates even more.

“It is not clear that the net effect would be a loosening of financial conditions that reduces the ECB’s appetite for rate cuts,” Marco Valli, global head of research at UniCredit, said.
Source: Reuters (Editing by Alison Williams)