Europe is beating inflation. Why can’t America declare victory?

Analysis by Anna Cooban, CNN

London (CNN) — Inflation may have tumbled from multi-decade highs on both sides of the Atlantic, but progress has stalled in the United States, with the Federal Reserve now expected to start cutting interest rates well after its European counterpart.

Annual US inflation, as measured by the Fed’s preferred gauge, the Personal Consumption Expenditures index, came in at 2.7% in March, accelerating from 2.5% in February. The Fed aims to keep inflation at 2% over the longer run.

Another measure of US inflation, the Consumer Price Index, has shown the same upward trend: In March, the CPI rose 3.5% compared with the same month in 2023, up from 3.2% in February.

Meanwhile, among the 20 countries that use the euro, annual consumer price inflation has slowed steadily since the start of the year. It stood at 2.4% in March.

The European Central Bank (ECB) looks set to start cutting interest rates in June, three months before the Fed is forecast to do the same, based on market expectations.

There are even indications that the Fed may do something that, until quite recently, seemed inconceivable — raise the cost of borrowing. Fed Governor Michelle Bowman said earlier this month that she would favor a rate hike “should progress on inflation stall or even reverse.”

So why does the United States appear to have a bigger inflation problem than Europe?

A difference of definition?

Some economists argue there isn’t actually much daylight between the US and European rates of inflation, pointing to a quirk in the US measures.

Unlike the ECB’s preferred gauge, both the PCE and the CPI include owner-occupiers’ housing costs — essentially a measure of how much money you could earn from renting out your home and hence forego if you live in it.

The measure is designed to track inflation in the real estate market while accounting for the fact that most Americans own their homes. But people don’t actually feel these hypothetical housing costs, said Paul Donovan, chief economist at UBS Global Wealth Management.

The weight given to owner-occupiers’ housing costs is much bigger in the US CPI than in the PCE — 32% versus 13%, according to consultancy Capital Economics — but both weights are still much larger than the 0% afforded to these costs in the eurozone’s key measure of consumer prices.

This transatlantic discrepancy exaggerates the recent differences between US and eurozone inflation, according to Simon MacAdam, deputy chief global economist at Capital Economics.

When using a different measure that, among other adjustments, strips out those hypothetical housing costs, MacAdam finds that core inflation rates — which exclude energy and food prices — have been “very similar” in the United States and Europe over the past six months.

“The US hasn’t got a fundamental problem of broad-based excessive price pressure, contrary to some of the recent narrative from commentators,” he wrote in a note last week.

Diverging economies

So if the levels of inflation are fundamentally similar on both sides of the Atlantic, then why are their respective central banks looking to start cutting interest rates at different times?

The simple answer is that, as MacAdam put it, “central banks will ultimately alter monetary policy in response to developments in the measure of inflation they target, not harmonized or adjusted measures.”

But it’s more complicated than that. “The (transatlantic) divergence is bigger when it comes to (economic) growth,” Carsten Brzeski, global head of macroeconomic research at ING, told CNN.

The International Monetary Fund expects the US economy to grow 2.7% this year, whereas for the eurozone it sees only a 0.8% expansion.

US employers are hiring at a historic clip, adding 303,000 jobs in March. Washington has also spent a lot more than European governments in recent years to support consumers and businesses through the pandemic, something that has kept consumer demand particularly robust in the United States.

Despite preliminary data Thursday that showed weaker-than-expected US growth in the first quarter, Treasury Secretary Janet Yellen told Reuters that the economy was still “firing on all cylinders.”

Europe’s economy is much weaker due, in part, to the lingering impact of an energy crisis. When Russia — which once provided more than 40% of Europe’s pipeline gas imports — launched its full-scale invasion of Ukraine in 2022, the region’s natural gas prices shot up to all-time highs.

As a result, annual inflation in the eurozone peaked at a much higher level than the PCE. The two rates hit 10.6% and 7.1% respectively in 2022.

The strength of the US economy makes it more likely that high inflation will make a sustained comeback, Brzeski said, which is making the Fed more hesitant than the ECB to start cutting rates in the summer.

Both the United States and the eurozone are grappling with labor shortages, which is forcing employers to hike wages in order to attract and keep workers and fueling inflation in the services sector, he noted. But, more broadly, US consumer demand appears stronger.

“We see the savings ratio of US households starting to come down, which means that people in the US are willing to tap into their savings in order to spend,” he said. “In general, European households are a bit more cautious.”

Davide Oneglia, director of European and global macroeconomics at research firm TS Lombard, takes a similar view. “The US consumer is more eager to spend because maybe he sees better prospects for himself in the labor market,” he told CNN.

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