Transatlantic Divergence of Economic Outlooks – Implications for Central Bank Policies

Walking around the streets of Berlin and New York in the last month, the feeling of an economic downturn is omnipresent. From talking to street-cart vendors in Jackson Heights to owners of Christmas market stalls in central Berlin, yellow cab drivers in Manhattan and artists in Prenzlauer Berg, dissatisfaction with increasing prices, weaker business, and economic policy was frequently mentioned, even more so in Berlin than in New York City.

U.S. consumer sentiment in December 2023 was at levels last seen during the Great Recession between 2007 and 2009. Meanwhile, 70 percent of Germans think that German economic conditions are going to worsen, a level similar to January 2009 and only 10 percentage points lower than during the height of the COVID-19 pandemic and the start of the Russian invasion of Ukraine. This data matched our own informal observations.

Based on those sentiments, one would expect similar recessionary economic conditions on both sides of the Atlantic. This is not the case. In 2023, the U.S. economy grew by 2.5 percent, while the German economy contracted by 0.3 percent, based on preliminary numbers. As a whole, the Eurozone is projected to have grown by 0.6 percent in 2023. After stagnating in the first quarter and growing by 0.2 percent in the second quarter of 2023, the Eurozone contracted by 0.1 percent in the third quarter. Data for the fourth quarter for the Eurozone is not yet available. These underlying differences in gross domestic product (GDP) growth trends across the Atlantic started in the fourth quarter of 2022 and have widened since. On January 17, the U.S. Commerce Department published stronger-than-expected retail data: U.S. retail sales rose by 0.6 percent in December compared to November and the U.S. economy added 216,000 jobs.

Contrary to the comparatively robust state of the U.S. economy, the public has a negative assessment of the economy’s state. One possible explanation for this discrepancy is the tone of economic news coverage. The Brookings Institution’s Ben Harris and Aaron Sojourner highlighted the role of news by demonstrating that the gap between economic news sentiment and the actual economic data has reached the most negative point since the 1980s. This pessimistic assessment started in 2018 and has further intensified since 2021.

Germany, the Eurozone’s biggest economy, represented 28.8 percent of the bloc’s GDP in 2022. In the fourth quarter, German GDP decreased by 0.3 percent on the previous quarter, leading to an overall contraction of the German economy by 0.3 percent in 2023. These numbers are preliminary publications. Given these developments, Germany is on the brink of a technical recession and increasingly looks to be the “tired man of Europe,” as Germany’s finance minister said at this year’s World Economic Forum. Instead of being the cornerstone of the Eurozone, Germany’s economy is currently holding economic progress back across the bloc.

In January, 57 percent of Germans assessed their personal economic situation as good, with 33 percent giving a mixed review. Looking at overall economic conditions, 51 percent gave a mixed review and 33 percent a negative. In contrast to the United States, this assessment is founded on explicitly recessionary underlying circumstances.

Despite these different economic developments in the United States and the Eurozone, the broad development of inflation rates has trended in the same direction. Following its September 2022 peak at 6.64 percent, core inflation in the United States has come down to 3.89 percent in December 2023 with overall inflation even decreasing to 3.29 percent. In the Eurozone, inflation measured by the Harmonised Index of Consumer Prices decreased from 9.2 percent in December 2022 to 2.4 percent in November 2023, before increasing again to 2.9 percent in December. This increase was caused mainly by the end of government subsidies for energy.

Based on this inflation data, the Federal Reserve and the European Central Bank (ECB) have both announced that interest rate cuts are likely this year, though with different schedules. In December, Federal Reserve Chairman Jerome Powell stated that the interest rate hikes are most likely over. At the same news conference, he disclosed that the Federal Reserve policy makers expected three quarter-point interest rate cuts over the course of 2024.

Yet in early January, cautionary voices from inside and outside the Federal Reserve warned of premature celebration. Members of the Federal Reserve Board, such as Christopher Waller, cautioned against cutting interest rates too early despite promising inflation and economic data. Similarly, the statement that the FOMC, the Fed’s policy committee, issued on January 31 opened with a statement that inflation remains elevated. At his January press conference, Chairman Powell reinforced that the Fed had no urgency to cut rates. Market participants had expected rate cuts as early as March, which fuelled the new stock rally to the S&P 500 all-time high on January 19, but they will likely reassess their expectations following Powell’s press conference

In Europe, ECB President Christine Lagarde has cautioned that the market’s hopes of interest rate cuts in the spring are neither very realistic nor helpful in the fight against inflation. She does not expect interest rate cuts before summer. In the face of declining inflation and much slower growth in the Eurozone, the ECB is pushing back on talk of rate cuts as hard as the Federal Reserve.

The reasoning for this similar approach despite different economic conditions (and the ECB’s decision to start interest rate hikes after the Federal Reserve) is driven by a combination of the following factors: first, the ECB has a single mandate for price stability, while the Federal Reserve’s dual mandate focuses on price stability and maximum employment. Therefore, insufficient signs of inflation coming down towards the 2 percent inflation target, as seen in December, have an even bigger weight for the ECB and lead to a higher reluctance to change course. This argumentation was also employed by ECB Governing Council members Robert Holzman and Joachim Nagel.

Second, the ECB is aware that factors such as increased shipping costs due to the geopolitical tensions in the Red Sea as well as strong wage data could make inflation in the Eurozone stickier. Christine Lagarde stated that inflation in the services sector and overall wage growth remain too high. She expects new information on the development of wage pressure to be available to the ECB by “late spring.” While J.P. Morgan has adjusted its expectation of the ECB’s first interest rate cut from September to June, the market overall still expects ECB interest rate cuts as early as April.

The disconnect between markets and decision-makers stems from two different understandings of the current situation. Central bank decision-makers focus on not repeating the “stop-start” approach to the inflation fight that had to be implemented due to policy mistakes in the past. Given the strong economic data, the risks could be even more pronounced in the United States, although Christine Lagarde explicitly mentioned it in Davos. Instead of solely listening to what central bank officials state, the market appears to have built its own expectations of future developments. A reconvergence of outlooks can be expected to start closer to the spring meetings.

For the foreseeable future, the main question that will continue to loom over central banks on both sides of the Atlantic is how to avoid premature celebrations of victory over inflation, holding interest rates high for a sufficiently long time to gain greater confidence that inflation is moderating, but not for so long as to slow economic growth. Walking around the streets of Berlin and New York in the coming months, we will feel the impact of those central bank policy decisions.

Jonas Piduhn is a Master of International Affairs student at Columbia University’s School of International and Public Affairs.

This post was written for the Council on Foreign Relations’ Renewing America initiative—an effort established on the premise that for the United States to succeed, it must fortify the political, economic, and societal foundations fundamental to its national security and international influence. Renewing America evaluates nine critical domestic issues that shape the ability of the United States to navigate a demanding, competitive, and dangerous world. For more Renewing America resources, visit https://www.cfr.org/programs/renewing-america and follow the initiative on Twitter @RenewingAmerica.