The past three years brought significant shifts in the monetary policy set by major central banks as the post-pandemic economic revival combined with supply-chain disruptions and geopolitical conflict in eastern Europe translated into a surge in inflation. 

In 2022, the US Federal Reserve, the Bank of England and the European Central Bank (ECB) raised their interest rates multiple times at record pace to the highest levels in over a decade. In simple terms, the increase in reference rates of the central banks would be expected to translate in higher borrowing costs for businesses and households, which in turn would be expected to tame consumer demand and eventually reduce inflation. 

As all three major central banks continued with further rate hikes in 2023, the debate then shifted to whether rates were becoming too restrictive and thus will eventually bring severe recessions. With inflation seeming to be in control by the third quarter of 2023, the three central banks stopped increasing rates and started to consider when it would be appropriate to start easing monetary policy. Indeed, during the second half of 2024, rate setters of these major economies started reducing rates to ensure a balance of stable inflation without stagnating the economy. 

Accordingly, it is fair to state that the actions taken by the US Federal Reserve, the Bank of England and the ECB between 2022 and 2024 were largely in tandem with each other. In contrast, the decisions taken at the latest monetary policy meetings held at the end of January 2025 highlight an evident divergence as the economies at both sides of the Atlantic are heading in different directions. 

Last week, the ECB decided to cut its key policy rates by 25 basis points, the fifth cut of that magnitude since June 2024. The ECB remains confident that inflation is stabilising towards its 2% medium-term target and believes its current rates are still somewhat restrictive. 

The statement published by the ECB Governing Council highlighted that wages and prices in certain sectors are still adjusting to the past inflation surge with a substantial delay, but there are evident signs that wage growth is moderating, and profits are partially buffering the impact on inflation. It is worth noting that although the eurozone economy is expected to grow minimally this year, the labour market remains resilient, with the unemployment level stable at an all-time low of 6.3%. 

The ECB remains confident that inflation is stabilising

As such, while market expectations are that another 25 basis points cut will be declared in March, there is a wider debate over whether more rate cuts will be declared towards the end of this year. This will ultimately depend on the macro-economic developments within the single currency bloc. 

In particular, the two largest economies within the euro area, Germany and France, both contracted in the fourth quarter of 2024, and both are also dealing with substantial domestic political issues that increase fears of stagnation. 

The monetary policy statement of the Federal Reserve, published on January 29, showed a different picture for the US as it highlighted  that economic activity continued to expand at a solid pace. 

Furthermore, the Fed believes that inflation remains somewhat elevated and when combined with a stable unemployment rate, rate setters decided to maintain the Federal Funds Rate unchanged at between 4.25% to 4.50%. The decision was largely in line with expectations but contrasted with the hopes of US President Donald Trump who a week earlier, during his intervention at the World Economic Forum Annual Meeting, demanded that interest rates should drop. In this respect, the Federal Reserve preserved its credibility by holding rates, highlighting the importance of having institutions working independently and free from political pressure. 

Furthermore, the Fed also adopted a more cautious approach by not committing to any further cuts. Fed chair Jerome Powell highlighted that the committee would need to see further progress in inflation going down before any rate reductions. The Fed acknowledged that current interest rate levels are restrictive for the US economy, but since the labour market is strong, there is no urgency for rate cuts. 

Effectively, the Fed is trying to avoid a situation where it eases conditions too early which would trigger another surge in inflation that would be more difficult to control.

The implications of the latest ECB rate cut can be observed in the drop in Euribor rates, which are reference rates for variable bank loans. Likewise, yields of short-dated fixed-income instruments also moved lower, resulting in a steeper yield curve.

Investors may, therefore, find it difficult to obtain attractive yields in short-term investments denominated in euro and would need to look at longer-term instruments to generate adequate returns in line with their investment targets.

Jonathan Falzon is a research analyst at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

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