• The ECB, poised to start cutting interest rates in June, faces a dilemma. With the Fed now likely to keep policy rates on hold for the foreseeable future, markets are questioning how much the ECB could diverge.
  • In our view, policy divergence is probable. We expect the ECB to cut rates in 2024 even if the Fed doesn’t – which is not without precedent.
  • However, the Fed’s prominence in global markets means the risks are skewed towards a slower pace of easing than what conditions might otherwise warrant, particularly if downward pressure on the euro intensifies.


Well before a third straight hotter-than-expected US inflation report in April led markets to abandon hopes for a US Federal Reserve (Fed) rate cut in June, Vanguard cautioned that a prudent Fed may choose to forgo rate cuts altogether in 2024, given unexpected US economic strength.

The euro area economy is in a different situation. Growth has tracked close to or below zero in recent quarters and inflation has moderated significantly towards the European Central Bank’s (ECB) 2% target. Currently, core inflation, which excludes volatile food, energy, alcohol and tobacco prices, is 2.7% on an annual basis and we expect it to fall towards 2% by the end of the year.

What’s more, there's little evidence of further inflation downstream. Although wage growth is elevated, it represents a healthy catch-up of real incomes and is moderating gradually. Meanwhile, inflation expectations remain well anchored and corporate price-setting behaviour has normalised.

In our view, the ECB will start to cut interest rates at its next monetary policy meeting in June. This would result in a divergence from the policy-setting of the Fed, which we expect to keep rates on hold for the rest of the year. This situation has raised eyebrows in the investment community. After all, it's common for ECB policy to follow that of the Fed, often with a lag. As shown in the chart below, the ECB’s hiking and cutting cycles came slightly after the Fed’s both in the early 2000s and between 2006 and 2009.

However, we believe this time is different. Domestic conditions in the euro area are sufficiently distinct to warrant a divergence in monetary policy. This line of thinking has been backed by key ECB policymakers, including ECB President Christine Lagarde.

There's a recent precedent of divergence between the two central banks. Towards the end of the last decade, the ECB cut rates slightly and expanded quantitative easing while the Fed embarked on a rate-hiking cycle. The ECB was justified then because domestic conditions were different. It won't be afraid to front-run the Fed this time either.

The ECB has diverged from the Fed before

 A line chart showing the midpoint of the US federal funds rate and the European Central Bank deposit rate since 2000. For much of the period shown, the ECB rate followed the path of the federal funds rate, usually with a lag. A divergence occurred from roughly 2016 through 2019, when the ECB maintained negative rates even as the Federal Reserve hiked rates by more than 2 percentage points.

Sources: European Central Bank, US Federal Reserve and Bloomberg, as of 31 March 2024.

That said, what comes after June is highly uncertain. This is because the greater the policy divergence priced in by financial markets, the less divergent policy is likely to be.

This negative feedback loop is driven by foreign-exchange markets. A growing policy rate differential between the US and Europe would exert downward pressure on the euro relative to the US dollar. This in turn would generate additional inflationary pressure in the euro area further down the road, making the ECB more cautious about cutting interest rates quickly.

Another risk to the ECB outlook is the recent rise in energy prices amid conflict in the Middle East. Brent crude oil is up nearly 15% since the start of the year and stands above $88 per barrel. According to our calculations, if Brent crude rises to more than $100 per barrel and stays there for at least two quarters, it would be enough to justify the ECB materially slowing the pace of monetary easing. 

The impact of a weaker euro on investment portfolios

A weakening euro has implications for globally diversified investment portfolios. For US- or UK-based investors, it suggests lower returns from euro area equities, as revenues buy fewer dollars or British pounds. (Vanguard recommends currency-hedging global bond investments, mitigating concerns about currency fluctuations.) From the perspective of euro area-based investors, a weaker euro suggests the opposite: stronger returns from equities denominated in US dollars (or sterling).

But markets can turn quickly, and our caveats against trying to time the markets apply equally to currency exchange rates. Long-term investors are well served by choosing an asset allocation that suits their financial goals and risk tolerances. 

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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