Europe is overcoming inflation. Why can’t America declare victory?

Europe is overcoming inflation. Why can’t America declare victory?

Inflation may have fallen from multi-decade highs on both sides of the Atlantic, but progress has stalled in the United States, with the Federal Reserve now expected to start cutting interest rates well behind its European counterparts.

Annual US inflation, as measured by the Fed’s preferred gauge, the Personal Consumption Expenditure index, reached 2.7% in March, up from 2.5% in February. The Fed aims to keep inflation at 2% over the long term.

Another measure of US inflation, the Consumer Price Index, has shown a similar upward trend: In March, the CPI rose 3.5% over the same month in 2023, up from 3.2% in February. Meanwhile, among the 20 countries that use the euro, annual consumer price inflation has slowed since the beginning of the year. It was at 2.4% in March.

The European Central Bank (ECB) appears poised to start cutting interest rates in June, three months before the Fed is expected to do the same, based on market expectations.

There are even signs that the Fed may do something that, until recently, seemed unthinkable – raise the cost of borrowing. Fed Governor Michelle Bowman said earlier this month that she would support a rate hike “should progress on inflation stall or otherwise.”

So why does the United States seem to have a bigger inflation problem than Europe?

Difference in definition?
Some economists argue that there really isn’t much sunshine between the US and European inflation rates, pointing to the oddity in the US move.

Unlike the ECB’s preferred gauge, both PCE and CPI include owner-occupier housing costs – essentially a measure of how much money you could earn from renting out your home and therefore giving up if you lived in it.

The measure is designed to track inflation in the real estate market while taking into account the fact that most Americans own their homes. But people don’t really feel the cost of this hypothetical housing, says Paul Donovan, chief economist at UBS Global Wealth Management.

The weight given to owner-occupant housing costs is much greater in the US CPI than in the PCE — 32% versus 13%, according to consultancy Capital Economics — but both weights are still significantly greater than the 0% given to these costs in the main zone measure euro for consumer prices.

This transatlantic discrepancy is exaggerating the recent divergence between US and eurozone inflation, according to Simon MacAdam, deputy chief global economist at Capital Economics.

When using a different measure that, among other adjustments, removes those hypothetical housing costs, MacAdam found that core inflation rates – which exclude energy and food prices – have been “remarkably similar” in the United States and Europe over the past six months.

“The US does not have a fundamental problem of broad-based excessive price pressures, contrary to some recent narratives from commentators,” he wrote in a note last week.

Diverse economy
So if inflation levels are essentially similar on both sides of the Atlantic, then why would their respective central banks want to start cutting interest rates at different times?

The simple answer is that, as MacAdam says, “central banks will ultimately change monetary policy in response to developments in their targeted measure of inflation, not coordinated or coordinated measures.”

But it’s more complicated than that. “The (transatlantic) difference is bigger when it comes to (economic) growth,” Carsten Brzeski, head of global macroeconomic research at ING, told CNN.

The International Monetary Fund expects the US economy to grow 2.7% this year, while for the eurozone it sees only 0.8% expansion.

US employers hired at a historic clip, adding 303,000 jobs in March. Washington has also spent more than European governments in recent years to support consumers and businesses through the pandemic, something that has kept consumer demand particularly robust in the United States.

Although Thursday’s preliminary data showed weaker-than-expected US growth in the first quarter, Treasury Secretary Janet Yellen told Reuters that the economy was still “firing on all cylinders.”

Europe’s economy is much weaker due, in part, to the lingering effects of the energy crisis. When Russia – which once provided more than 40% of Europe’s pipeline gas imports – launched a massive invasion of Ukraine in 2022, natural gas prices in the region soared to all-time highs.

As a result, annual inflation in the eurozone peaked at a higher level than PCE. Both rates will reach 10.6% and 7.1% respectively in 2022.

The strength of the US economy makes it more likely that high inflation will make a sustained comeback, Brzeski said, making the Fed more hesitant than the ECB to start cutting rates in the summer.

Both the United States and the eurozone are struggling with labor shortages, which are forcing employers to raise wages to attract and retain workers and fueling inflation in the service sector, he said. But, more broadly, US consumer demand appears stronger.

“We’re seeing the US household savings ratio start to decline, which means that people in the US are willing to tap into their savings to spend,” he said. “In general, European households are a little more cautious.”

Davide Oneglia, director of European and global macroeconomics at research firm TS Lombard, takes a similar view. “The US consumer is more interested in spending because maybe he sees better prospects for himself in the labor market,” he told CNN.