As the United States navigates through increasing financial pressures alongside signs that the Federal Reserve is nearing the end of its tightening cycle, a distinct economic divergence between the U.Sand other global regions appears to be on the horizonFor Europe, the pivotal question lies in whether the economic and monetary policies within the Eurozone will continue to drift apart from those in the U.Sand how long this divergence might lastThe dynamics of these choices could shape the economic landscape significantly across both continents.

Although the recent financial strain poses a downside risk to Europe’s economic growth, we still anticipate supportive policies being implemented throughout the year, alongside robust fundamentals among consumers and businessesThere is a worrying yet increasingly prevalent trend indicating that inflation remains strong and increasingly entrenched

This backdrop suggests that the European Central Bank (ECB) might find itself in a position where it has to hold off on interest rate cuts longer than the markets currently expectTo bolster this assertion, several key factors warrant consideration.

The financial pressures emanating from the U.Sare presenting fresh downside risks to growth in the Eurozone.

Up to this point, the effects on consumer and business confidence in Europe, as well as the financing costs for European banks, have been relatively restrainedHowever, these risks need continued vigilanceA downturn in consumer and business confidence could impede the anticipated pace of economic growth, while rising financing costs might exacerbate the trend of slowing private sector credit growth — a notable decline from a yearly GDP percentage of 6-7% last summer to just 1% by the first quarter of 2023.

In comparison, the European banking sector demonstrates greater resilience.

Although risks associated with heightened financial strains should not be overlooked, the liabilities on balance sheets within European banks appear to be more robust than those of their American counterparts, partly due to lesser structural competition from money market funds against deposits in the U.S

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On the asset side, the ECB has been the predominant purchaser of government bonds, effectively absorbing all net-issued government bonds over the past decadeThis strategy has been pivotal in maintaining stability in the European financial markets.

The relative supportiveness of policy, along with the foundational strength among consumers and businesses, substantiate growth in the Eurozone.

While monetary policy is tightening within Europe, the pace of change remains modest, and fiscal policy continues to be accommodatingThe fundamentals surrounding consumers and businesses have shown remarkable strengthNominal income growth has reached historical highs, and we forecast that with overall inflation expected to retreat to around 3% by the end of this year, real income growth is likely to accelerate

Furthermore, the unemployment rate is currently at historical lows, and corporate profitability is soaring, with profit margins hitting pre-global financial crisis levelsIn summary, barring any unforeseen downturns, the positive fundamentals suggest that growth momentum could outpace the ECB’s current predictions.

More evidence points to inflation being persistent and particularly resilient.

Despite the core inflation rate in the Eurozone peaking at 5.7% in March, our forecasts indicate that due to the ongoing strong increases in core services prices and record wage growth, we are projecting core inflation rates that are roughly 0.5-0.6 percentage points higher than the ECB's outlook for 2023 and 2024. Even though energy prices have seen some weakness recently, consumer inflation expectations rebounded to levels nearing 3% as of March

This suggests that inflation is becoming more entrenchedIn contrast to the U.S., Eurozone data remains striking, with both core inflation and wage growth on the riseWe anticipate that inflation in the Eurozone will outpace that of the U.Sand the average of G7 countries over the next few years.

The ECB might extend the duration of interest rate hikes, with market pricing facing upward risks.

During its May meeting, the ECB opted to slow the pace of interest rate hikes to 25 basis points, indicating sensitivity to the recent slowdown in credit growth and risks linked to financial pressuresNevertheless, the bank’s own projections align with a terminal interest rate of up to 4.0%, suggesting that the risks surrounding these forecasts could lean towards the upside.

Should financial pressures escalate, it could lead to non-policy-related tightening in monetary conditions