ECB and Fed Policy Split Sets Up the Euro for a Deeper Decline

The European Central Bank (ECB) and the Federal Reserve (Fed) have taken divergent paths in their monetary policy, with the Fed expected to cut interest rates twice in 2025 while the ECB continues its policy-easing cycle at the current pace. This policy split, driven by differing inflation dynamics and economic performances, has set the stage for a deeper decline in the euro against the US dollar.

The Fed's hawkish stance is a response to broad-based and persistent inflation in the US, with core inflation remaining elevated despite a slowdown in headline inflation. This has led market participants to expect two interest rate cuts in 2025. In contrast, the ECB has been more dovish, with market pricing in four interest rate cuts of 25 basis points each in 2025. This divergence in policy expectations is reflected in the EUR/USD exchange rate, which has been under pressure due to the ECB's dovish stance.

The differing inflation dynamics between the US and the euro area are also reflected in the performance of their respective economies. The US economy has been growing solidly, while the euro area economy has been weakening. This has further contributed to the policy divergence between the ECB and the Fed, with the ECB focusing on stimulating economic growth, while the Fed remains focused on controlling inflation.

The structural differences in the euro area economy, particularly the larger manufacturing sector in Germany, contribute to the varying impact of high interest rates on economic activity. Demand for manufactured goods is more interest rate sensitive than demand for services, and manufacturing firms typically have larger capital expenses, making their supply decisions more sensitive to interest rate changes. As a result, high interest rates have depressed economic activity more in those euro-area countries with large manufacturing sectors, such as Germany, compared to countries with smaller manufacturing sectors, such as Spain.

In conclusion, the policy split between the ECB and the Fed, driven by differing inflation dynamics and economic performances, has set the stage for a deeper decline in the euro against the US dollar. The structural differences in the euro area economy, particularly the larger manufacturing sector in Germany, contribute to the varying impact of high interest rates on economic activity. As the ECB and the Fed continue to diverge in their monetary policy, the EUR/USD exchange rate is likely to remain under pressure, with the euro potentially facing a deeper decline.