The U.S. and Europe’s Diverging Inflation Fights

April 26, 2024

Inflation showed little signs of letting up in March, with the Federal Reserve’s preferred inflation gauge stalling. This has pushed the presumed timeline for the Fed to begin cutting interest rates by months, behind that of their European counterpart.

Inflation has come down significantly from multi-decade highs on both sides of the Atlantic. Still, progress has stalled in the U.S., with the personal consumer expenditures (PCE) index showing that prices increased 2.7% on an annual basis in March. That is an acceleration from February’s 2.5% annual increase and higher than Wall Street analysts had been expecting.

The more commonly cited consumer price index (CPI) showed a similar dynamic, with inflation accelerating to a 3.5% annualized rate in March, up from 3.2% the month prior.

At the same time, inflation across the 20 nations that encompass the European Union has declined steadily throughout the year, falling to 2.4% in March.

This has cleared the way for the European Central Bank to begin cutting rates in June, while recent signals from the bond markets suggest that the Fed is unlikely to make cuts before September.  

The difference between the U.S. and E.U.’s fight against inflation may have more to do with methodology than economics, however. 

Both the PCE and CPI calculations use something known as owners’ equivalent rent (OER), which is essentially a measure of how much a homeowner could earn if they rented out the home. The measure is intended to track inflation in the housing market while also accounting for the fact that most Americans own their home. 

The weighting that the PCE and CPI assign to this metric, 13% and 32%, explain the frequent discrepancy between the two. CPI tends to run hotter, largely because it gives additional weight to OER than the PCE does. The European Central Bank’s preferred inflation gauge does not account for OER, which may be exaggerating the difference between American and European inflation in recent months.

According to an analysis from Capital Economics, the “core” inflation rate, which excludes volatile components like food and energy, has been “very similar” in the U.S. and E.U. over the past six months.

Ultimately, the fact that the ECB may end up cutting rates before the Fed has more to do with their diverging economies. The International Monetary Fund expects the US economy to grow 2.7% this year, whereas for the eurozone it sees only a 0.8% expansion.

The strength of the U.S. economy makes it far more likely that inflation will make a sustained comeback, which makes the Fed more hesitant than the ECB to cut interest rates. 

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