The unexpected strong growth of the U.S. economy has raised expectations that U.S. interest rates will be higher than European rates next year, but this poses problems for President-elect Trump's trade ambitions. The gap between U.S. and eurozone interest rates is set to widen, which has already pushed up the value of the dollar and may undermine his efforts to boost U.S. exports.
Trump's issues may soon become a dilemma for Fed Chairman Powell. During Trump's first term, similar interest rate gaps often frustrated Trump and became a trigger for his regular attacks on the Fed chairman and his colleagues. With Trump about to return to the White House, another divergence between the Fed and its global peers may rekindle similar situations.
Derek Tang, an economist at LH Meyer/Monetary Policy Analytics, said, 'If Trump attacks the Fed for not taking action, I wouldn’t be surprised. This time, the Trump administration is more organized, so this very organized approach to tariffs and negotiations with other countries could lead to a more sustained appreciation of the dollar, with monetary policy being just one part of it.'
Eight years ago, at the beginning of Trump's first term, as the Fed raised rates while the European Central Bank kept rates below zero, a gap began to emerge between U.S. and European rates. Trump fiercely criticized this widening gap, blaming the Fed's actions for the dollar's appreciation against other currencies and harming U.S. trade.
Now, both central banks are easing policies, but Europe’s urgency is much greater as the European Central Bank is trying to support a weak economy. In the U.S., expectations on how much Powell and his colleagues will cut rates have eased due to strong economic growth and robust consumer demand.
Federal Reserve officials will release their updated interest rate forecasts after a two-day policy meeting that concludes on Thursday, Beijing time.
"Increasingly weakening"
Diane Swonk, chief economist at KPMG, stated, 'The European economy is increasingly weakening, and they are more eager for rate cuts than the U.S., which means the divergence between the two central banks will be greater.'
With the Fed's rates now more than one percentage point higher than the European Central Bank's main lending benchmark, the dollar has appreciated 5% against the euro this year. Market expectations suggest that the interest rate gap between the two countries may widen to more than 2 percentage points next year, which could further strengthen the dollar, completely contrary to Trump's wishes.
In recent years, Europe has struggled to achieve economic growth, and economists believe this situation will persist until 2025.
In response to post-pandemic inflation, central banks around the world have entered a rate hike cycle, and compared to the U.S., the European economy is more severely impacted by high rates, while Europe's dependence on Russian energy has also become a hindrance to expansion following the Russia-Ukraine conflict. Trump's tariff threats to European economies and other major trading partners like China are seen as further risks to economic growth on the continent.
Meanwhile, U.S. growth is outpacing pre-pandemic trends. The fact that energy independence and most U.S. homeowners hold fixed-rate mortgages means that stricter Fed policies have not significantly impacted consumer spending.
At the end of last year, economists predicted that the U.S. economic growth rate for 2024 would be only 1%. However, the surprising resilience of the U.S. economy, now coupled with concerns that Trump's tariffs and tax cuts may reignite inflation, is steadily reducing bets on Fed rate cuts in 2025.
Maintaining high levels for a long time
Like the European Central Bank, the Federal Reserve is still expected to cut rates by 25 basis points this month, but the market currently expects the Fed to cut rates only three times next year, while they anticipate a significantly larger reduction from the European Central Bank.
Moreover, some of Trump's policies may exacerbate this divergence. Tariffs that lead to rising inflation may cause the Fed to keep interest rates elevated for a longer period, leading to further strengthening of the dollar.
The dollar index has risen about 6.3% so far this year, putting it on track for its best annual performance since 2015. Some on Wall Street believe this has pushed the dollar's valuation to high levels, laying the groundwork for a weaker dollar in the second half of 2025.
Unlike during Trump's last term, when the Fed ultimately cut rates in the face of an economic slowdown, there are now signs of potential economic changes that may indicate a tightening monetary policy will continue.
In recent years, productivity growth in the U.S. has significantly accelerated, while most European countries have not experienced this. The surge in illegal immigration in the U.S. post-pandemic has also helped businesses meet consumer demand, while Trump has vowed to reverse this trend.
All of this may have pushed up what economists call the neutral interest rate, which is the level of interest rates that neither dampens nor stimulates demand. Federal Reserve policymakers' estimates of this number have been steadily rising over the past year, and they indicate that this could mean they will eventually stop cutting rates at a level higher than before the pandemic.
If the strong performance of the U.S. economy poses headwinds for Trump regarding interest rates and the dollar, then a stronger U.S. economy and a stronger currency could at least help withstand some of the inflation shocks brought by tariffs.
Scott Lincicome, vice president for general economics and trade at the Cato Institute, said, 'It’s a bit like the other side of this issue; a strong U.S. economy will make the impact of tariffs more tolerable, and a stronger dollar will make it easier for consumers to tolerate the impact of tariffs.'
Article forwarded from: Jinshi Data