The diverging paths of economic policy on either side of the Atlantic - 28 October 2024
Europe and the United States may be similar in many respects but when it comes to policy mix, they are on diverging paths. In Europe, fiscal policy seems so constrained that it looks like it is once again all down to the European Central Bank. The opposite is true in the US, where the Federal Reserve appears to be the only constraint on fiscal policy. The burning question remains as to whether this policy mix is stabilising or destabilising, and how it will impact the financial markets.
The October PMI surveys seem to suggest that the manufacturing sector is stabilising at a low level and that the services sector is settling (cf. chart 1). However, it is the geographical divergence between the United States and the rest of the world that is most striking (cf. chart 2).
An article published on 19 October 2024 in the weekly edition of The Economist successfully captures the mood: “The American economy: The envy of the worldˮ. A pessimist would tell you that this type of article in this magazine tends to represent a peak, just before a fall. This specific article offers an unbiased list of America’s strengths: its productivity, its cheap energy and the power of its financial markets. However, these structural benefits are nothing new. Of course, its cheap energy is a huge source of resilience for the United States compared to Europe in particular, especially since Russia’s invasion of Ukraine. In the shorter term, the diverging paths of the regions’ economic policies are a major factor in the divergence of their economic climates. According to the latest figures from the IMF, the cyclically adjusted primary fiscal balances, which measure the net contribution of the government’s budget to GDP, are expected to show a gap of 3% of GDP in 2025 (cf. chart 3).
As inflation is now on target at 2%, growth is sluggish and budgets are strengthening, the risk for 2025 is that inflation will be too low in the eurozone. In the ECB, the traumatic memory of the 2010s, when inflation was persistently below target, persists. The ECB will therefore continue to lower its rates to the natural rate of interest of 1.75%–2% or beyond, following a stable and predictable trajectory.
In the United States, the current macroeconomic equilibrium is being called into question. While inflation is on target, the labour market is operating at full employment and growth is relatively stable, the budget deficit is 6% of GDP (the cyclically adjusted primary deficit is 3.4%). Furthermore, there is nothing to suggest that this might improve, regardless of who wins the presidential election on 5 November. Just how much room for manoeuvre does the Federal Reserve have in this context ?
There is no definitive answer to any of these questions at the moment. They are echoed in the foreign exchange market where the dollar grows ever stronger and in the international bond markets where long-term rates are experiencing extreme volatility.
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