Fed and ECB meetings point to divergence in paths

Federal Reserve (Fed) chair Jerome Powell had the honour of kicking off the 2025 season for the major central banks this week, swiftly followed by the chore of having to plead the fifth every time he was asked about a President Trump policy.

The Fed for its part held rates and largely held back its words. By contrast, the European Central Bank (ECB) yesterday cut rates by 25bp and its president, Christine Lagarde, presented a much more confident vision for the continuing ECB cutting cycle.

The Fed meeting, as we had expected, was pretty much a non-event. Powell described the Fed’s policy as still restrictive, but with the economy in a good place there was no need to “hurry to adjust the policy”. Indeed, US annualised Q4 growth data released on Wednesday of 2.3% was accompanied by a very strong personal consumption number of 4.2%. Meanwhile, US core inflation is forecast to fall only marginally to 2.5% this year from 2.8% in 2024, with some potential upward pressure from pending White House policies. The market has been largely unchanged post-Fed, with two cuts still priced in for this year in the US, in line with the Fed’s own most recent ‘dot plot’ projections from December. The Fed, and subsequently the market, will continue to be data dependent.

Lagarde was able to paint a different picture than her US counterpart. She declared that the disinflation process is “well on track”, and that while energy base effects may mean European inflation fluctuates this year, the 2% target will be hit in 2025 and is on course to be sustainably achieved. With goods inflation in Europe at 0.5%, it has been services inflation which has lagged at 4% as a result largely of sticky wages. But, confidence here comes from “all indicators heading downwards” including vacancies, wage trackers and surveys. Simultaneously, while the ECB estimated in its December forecasts that GDP growth in 2025 will be 1.1%, the downside risks to this forecast have increased since that assessment;  European Q4 annualised growth numbers came in at 0.0% on Thursday, below the forecast 0.2%, vindicating the continued easing of monetary policy.

However, while concerns for European growth are justified, Lagarde also outlined a few reasons why a floor for European growth may be in place. The first is the labour market’s continued resilience with unemployment remaining at historical lows, which, coupled with solid real income growth, should continue to drive consumption. The second is that savings buffers have increased dramatically since 2022, with the European savings ratio at around 15% versus around 4.5% in the US, providing a tailwind for growth if consumers started to spend some of that buffer. And finally, Lagarde alluded to the most recent release of the broad money supply, which hadn’t passed us by on the desk. Here, we saw a further acceleration of lending to the real economy in Europe with households and corporates combining to borrow €53bn more in December alone, the strongest number seen since the beginning of the hiking cycle. And so, the transmission mechanism does appear to be working, or as Lagarde framed it, previous cuts are “channelling through into the economy” – albeit with work still to be done.

The combination of encouraging inflation data and sluggish growth means we should continue to see cuts from the ECB at forthcoming meetings, and the destination still feels far away with Lagarde admitting that it is “entirely premature” to talk about where the neutral rate is (our guess is around 2%).

Looking at credit then, we think investors in Europe should remain focused on the higher quality end of the credit spectrum, given the sluggish growth and especially considering the threat of tariffs. However, considering the supportive tailwind of continued cuts, macroeconomic fundamentals suggesting a floor and European credit still offering a spread premium over the US, we think European credit can continue to perform well.