June Eurozone Inflation: Further Reason To Keep Rates Low?

The world’s two largest economies appear to be continuing down different paths.

The likely result is that the euro will find itself stronger than the dollar in the coming months. However, that depends on whether the data trends continue.

In fact, tomorrow we’ll be getting a hint as to whether Europe and the US are diverging or converging as the recovery gets underway.

An interesting thing to note was yesterday’s comments from ECB President, Christine Lagarde. The ECB head informed EU leaders that she expected the economy to return to pre-pandemic levels by the first quarter of next year.

She also expects inflation to keep rising until autumn but insisted that the higher rate would be transitory.

So what’s next for the two largest economies?

The context matters

The thing is, the pre-pandemic situation was very different for the US and the EU.

So, if both economies were aspiring to return to where things were before covid, they would be aiming for rather different targets. And this has important implications for the markets.

Specifically, pre-covid, the EU was growing at an anemic 1% annual, which was half the rate of the US. Moreover, the Fed was on a rate-hiking trajectory, while the ECB had kept rates negative.

Therefore, the “normalization” of rates for the US implies cutting back on asset purchases and eventually raising rates. whereas for the ECB, “normalization” ECB implies negative rates, and potentially further expanding the balance sheet.

So, what does this mean for the EURUSD?

At first glance, lower interest rates for the common currency would suggest weakness. Having said that, it’s not necessarily true when we compare inflation expectations.

Economists expect euro area inflation to be 1.4% this year, while US inflation is likely to come in at 2.1%. Both of these projections are considered to be quite optimistic (especially on the US side). However, the real yields in Europe are higher. In fact, we can expect them to remain so, even if the Fed starts tapering.

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