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The European Central Bank may need further interest rate cuts if global borrowing costs are pushed up by the U.S. Federal Reserve’s maintenance of its restrictive monetary policy, a euro zone leader said.
Fabio Panetta, head of Italy’s central bank, said in a speech on Thursday that if the Fed keeps interest rates on hold for longer than markets expect or even raises them, it would “likely strengthen the case for a rate cut.” [by the ECB] rather than weakening it.”
Panetta’s comments contradict warnings from other ECB rate-setters that they should avoid diverging too much from the Fed and underscore how doubts about the direction of U.S. monetary policy are fueling tensions in Europe.
Investors have trimmed their bets on how often the Fed will cut interest rates this year after its Chairman Jay Powell said borrowing costs would have to stay at 23-year highs for longer than expected as U.S. inflation strengthened proved more persistent than predicted.
Some traders are now even pricing in Fed rate hikes over the next 12 months.
The ECB has signaled it will most likely begin cutting its key deposit rate from an all-time high of 4 percent at its next policy meeting on June 6, as long as price pressures continue to ease in line with its forecasts.
But fears of a more hawkish Fed stance have pushed bond yields higher in Europe as investors scale back the number of ECB interest rate cuts they expect this year.
Panetta told an ECB event in Frankfurt that it was an “important question” to what extent the central bank’s policy could diverge from that of the Fed, and he warned of the dangers of not taking into account the “strong spillover effects” of the dominant ones US bond markets went hand in hand with those in the rest of the world.
“If markets expect interest rates to fall but the Fed leaves them unchanged due to strong inflation data, for example, the rest of the world faces an unexpected tightening of monetary policy,” he said. “Tightening in the US has a negative impact on inflation and production in the eurozone.”
He added that “downside risks to the outlook mean the ECB should consider the possibility that monetary policy could become ‘too restrictive’ in the future.”
His comments were supported by estimates from French bank BNP Paribas that if European bond yields rose by half a percentage point from the impact of U.S. markets, additional ECB rate cuts of 0.2 percentage points would be needed to offset the impact of tighter monetary policy balance financial conditions.
However, other members of the ECB’s interest rate-setting Governing Council expressed concerns about committing to significantly greater easing after June, given the risk that this would lead to a devaluation of the euro and thus an increase in inflation through rising import prices.
“I would definitely be in favor of an interest rate cut in June,” said Bundesbank chief Joachim Nagel on Wednesday. “However, such a move would not necessarily be followed by a series of interest rate cuts.”
Austria’s central bank chief Robert Holzmann said: “It would be difficult for me if we moved too far away from the Fed.”
ECB Vice President Luis de Guindos told Le Monde this week that the central bank must “take into account the impact of exchange rate fluctuations.”
He also said the transatlantic divergence in interest rates could trigger higher “capital flows” from Europe to the US and increase risks for the banking sector.