That may sound like a good problem to have, but it spells trouble for President-elect Donald Trump’s trade ambitions. The gap between US and euro zone interest rates, which is set to widen, has already driven up the value of the dollar and could undercut his efforts to boost US exports.
Trump’s problem could soon become Jerome Powell’s, too. A similar rate gap in Trump’s first term was a frequent irritant to the president, and a trigger for regular bashing of the Federal Reserve chair and his colleagues. Now that Trump’s heading back to the White House, another divergence between the Fed and its global peers may be the cue for more of the same.
“I wouldn’t be surprised if Trump goes after the Fed for not acting in line,” said Derek Tang, an economist at LH Meyer/Monetary Policy Analytics. “This time around, the Trump administration is more organized, and so this very organized approach to tariffs and negotiations with other countries is probably going to lead to a more sustained rise in the dollar. And monetary policy is a part of that.”
Eight years ago, at the dawn of the first Trump administration, a US-Europe gap started to emerge as the Fed increased rates while the European Central Bank held them below zero. Trump slammed the growing disparity, blaming the Fed’s actions for driving up the dollar versus other currencies and hurting US trade in the process.
Now, both central banks are easing policy – but there’s much more urgency in Europe, where the ECB is seeking to shore up a flagging economy. In the US, expectations for how much Powell and his colleagues will cut rates have tempered, amid solid US growth and robust consumer demand.
Fed officials will release their own updated rate forecasts after their two-day policy meeting that ends Wednesday.
‘Weaker by the Day’
“Europe is looking weaker by the day,” said KPMG chief economist Diane Swonk. “They’re going to be more anxious to cut than we are, and that means more divergence for now.”
With the Fed’s rate already more than one percentage point above the ECB’s main lending benchmark, the dollar has strengthened 5% against the euro this year. The rate gap is poised to widen to more than 2 percentage points next year, according to market expectations, potentially further driving up the greenback — exactly the opposite of what Trump wants.
Europe has struggled in recent years to achieve much growth, and economists see that continuing into 2025.
Higher interest rates to tackle post-pandemic inflation hit the region harder than the US, and Europe’s dependence on Russia for energy also proved to be a headwind for expansion after the invasion of Ukraine. Trump’s tariff threats, aimed at European economies as well as other large trading partners such as China, are seen as a further risk to growth on the continent.
Meanwhile the US has been growing at a pace that exceeds the pre-Covid trend. Energy independence, and the fact that most American homeowners hold fixed-rate mortgages, has meant that tighter Fed policy hasn’t taken as big a bite out of consumption.
Late last year, economists were predicting US growth of just 1% for 2024. But the surprising resilience of the US economy — now coupled with concern that Trump’s tariffs and tax cuts could reignite inflation — has steadily reduced bets on rate cuts in 2025.
Higher for Longer
Like the ECB, the Fed is still expected to cut rates by a quarter point this month, but markets are now pricing just three cuts next year – while they expect substantially more in Europe.
And some Trump policies could exacerbate the divergence. Tariffs that drive up inflation could lead the Fed to keep its rates higher for longer, resulting in an even stronger dollar.
The Bloomberg Dollar Spot Index has risen some 6.3% so far this year, putting the gauge on track for its best year since 2015. To some on Wall Street, that’s pushed the US currency’s valuation to high levels that lay the groundwork for weakness in the latter portion of 2025.
Unlike during the last Trump administration, when the Fed eventually cut rates in the face of a slowdown, there are some signs of underlying economic shifts that might mean tighter money is here to stay.
The US has seen a marked pickup in productivity growth over the past few years whereas other countries, including those in Europe, mostly haven’t. A surge in immigration after the pandemic — which Trump is vowing to reverse — also helped companies keep up with consumer demand.
All of this likely pushed up what economists refer to as the neutral rate of interest, where policy neither weighs on nor stimulates demand. Fed policymakers, whose estimates of this figure have been steadily increasing over the past year, say that might mean they’ll ultimately stop cutting rates at a higher level than they would have before the pandemic.
If US outperformance represents a headwind for Trump when it comes to interest rates and the dollar, the stronger American economy and stronger currency may at least help it withstand some of the inflationary shocks from tariffs.
“That’s kind of the flip side to this,” said Scott Lincicome, vice president for general economics and trade at the Cato Institute. “A strong US economy would make a tariff hit more tolerable and a stronger dollar would make a tariff hit more tolerable for consumers.”
