Europe Is Beating Inflation. Why Can’t America Declare Victory?

Inflation has decreased significantly from historically high levels in both the United States and Europe. However, the United States is seeing a delay in progress, as the Federal Reserve is currently anticipated to begin reducing interest rates after the European Central Bank.

In March, the annual US inflation rate, as assessed by the Personal Consumption Expenditures index, increased to 2.7% from 2.5% in February. The Federal Reserve’s objective is to maintain a long-term inflation rate of 2%.

The Consumer Price Index, another indicator of inflation in the United States, has also exhibited a similar increasing trajectory. The Consumer Price Index (CPI) increased by 3.5% in March, compared to the corresponding month in 2023. This is a rise from the 3.2% recorded in February.

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Europe Is Beating Inflation. Why Can’t America Declare Victory?

Meanwhile, inside the group of 20 countries that utilize the euro as their currency, the annual consumer price inflation rate has consistently decreased since the beginning of the year. The percentage was 2.4% in March.

Market predictions suggest that the European Central Bank (ECB) is likely to begin reducing interest rates in June, which is three months ahead of the forecasted rate decrease by the Federal Reserve (Fed).

There are even signs that the Federal Reserve may take action that, until recently, seems unimaginable – increase the interest rate for borrowing. In a recent statement, Fed Governor Michelle Bowman expressed her support for a potential increase in interest rates if there is a slowdown or reversal in inflation.

What is the reason the United States has a more significant inflation issue than Europe?

Several economists contend that the disparity in inflation rates between the United States and Europe is insignificant, attributing it to a peculiar aspect of the measurement methods used in the United States.

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Europe Is Beating Inflation. Why Can’t America Declare Victory?

In contrast to the European Central Bank’s preferred measure, both the Personal Consumption Expenditures (PCE) and the Consumer Price Index (CPI) take into account the expenditures associated with owning a home, which includes the potential rental income that could be earned if the property was rented out instead of being occupied by the owner.

The plan aims to monitor inflation in the real estate sector, considering the high rate of homeownership among Americans. According to Paul Donovan, the head economist at UBS Global Wealth Management, people actually need to experience these theoretical housing expenses.

The US Consumer Price Index (CPI) assigns a significantly higher weight to owner-occupiers’ housing expenses compared to the Personal Consumption Expenditures (PCE) index. Specifically, the CPI assigns a weight of 32% to these costs, while the PCE assigns a weight of 13%. In contrast, the eurozone’s primary measure of consumer prices does not assign any weight (0%) to owner-occupiers’ housing costs.

Simon MacAdam, deputy chief global economist at Capital Economics, argues that the recent discrepancies between US and eurozone inflation are magnified by this transatlantic discrepancy.

When employing an alternative metric that eliminates hypothetical housing expenses and incorporates additional modifications, MacAdam discovers that core inflation rates, excluding energy and food prices, have exhibited high similarity in the United States and Europe during the previous six months.

“Contrary to recent commentary, the United States does not have a fundamental issue of widespread and excessive price pressure,” he stated in a note last week.

Economies that are moving in different directions or diverging from one other.

If the levels of inflation are essentially comparable on both sides of the Atlantic, then why are their respective central banks planning to initiate interest rate reductions at separate moments?

In essence, as MacAdam succinctly stated, central banks would modify their monetary policies based on the specific measure of inflation they aim to control rather than relying on harmonized or adjusted measures.

However, the situation is more intricate than that. “The divergence between the two sides of the Atlantic, particularly in terms of economic growth, is significant,” stated Carsten Brzeski, the global head of macroeconomic research at ING, in an interview with CNN.

According to the International Monetary Fund, the US economy is projected to see a growth rate of 2.7% this year, while the eurozone is expected to expand by only 0.8%.

In March, US firms experienced a significant surge in hiring, with the addition of 303,000 jobs marking a historic milestone. The United States government has allocated significantly more funds than European governments in recent years to provide support for consumers and businesses throughout the pandemic, resulting in a sustained and strong level of consumer demand in the United States.

Although the initial figures on Thursday indicated a lower-than-anticipated growth rate for the US economy in the first quarter, Treasury Secretary Janet Yellen expressed to Reuters that the economy is still performing quite well.

Europe’s economy has been significantly weakened, partly due to the enduring effects of an oil crisis. Following Russia’s complete invasion of Ukraine in 2022, the prices of natural gas in Europe, which used to rely on Russia for almost 40% of its pipeline gas imports, skyrocketed to unprecedented levels.

Consequently, the eurozone experienced significantly greater annual inflation than the PCE. The two rates reached 10.6% and 7.1% in 2022, respectively.

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Europe Is Beating Inflation. Why Can’t America Declare Victory?

According to Brzeski, the robustness of the US economy increases the probability of a significant resurgence of high inflation. This is causing the Federal Reserve to be more cautious than the European Central Bank in initiating interest rate reductions during the summer.

Both the United States and the eurozone are currently dealing with labor shortages. This has led firms to increase pay to attract and retain workers, which in turn is contributing to inflation in the services sector. However, in a broader sense, the demand from US consumers seems to be stronger.

“The savings ratio of US households is decreasing, indicating that people in the US are willing to use their savings for spending,” he stated. “Typically, European households tend to be more prudent.”

Davide Oneglia, the director of European and global macroeconomics at research firm TS Lombard, has a comparable perspective. “The US consumer is exhibiting a greater inclination to engage in spending due to a potentially improved outlook for their own employment situation,” he stated in an interview with CNN.

SOURCE – (CNN)