Fiscal Policy - Inflation and Interest Rates in the US, EU & UK

The following is a table showing the US, EU and UK base interest rates compared to inflation. We can also see the difference between these figures or “Inflation Margin Rate” alongside.

As of September, the United Kingdom appears to be lagging behind the US and EU in adjusting interest rates in response to inflation trends. With an inflation rate of 1.7% and interest rates at 4.75%, the UK's Inflation Margin Rate (IMR) stands at 3.05%. This figure is significantly higher than the EU's IMR of 1.3%, suggesting differing monetary strategies.

Variations in Inflation and Market Size

A possible explanation for this discrepancy could lie in structural differences:

1. Market Size and Composition:

   - The EU's larger and more diverse economic area likely experiences varied inflation trends across member states. For instance, northern EU states may face lower inflation rates compared to southern states. Aggregated EU inflation figures might oversimplify these regional disparities.

   - In contrast, the UK's smaller and more unified market might exhibit lower internal inflation variation, influencing its monetary policy choices.

2. Core Inflation Concerns:

   - Central banks often weigh core inflation—which excludes volatile components like energy—more heavily in their decisions. If the UK’s inflation is driven more by factors such as energy costs, this might justify their caution in reducing interest rates further.

Bank of England's Cautious Approach

The Bank of England appears hesitant to lower interest rates aggressively, despite the relatively wide IMR. This contrasts with the US Federal Reserve, which has shown a proactive stance in supporting economic growth. The UK’s conservative approach likely reflects concerns about persistent inflationary pressures, particularly if they stem from energy or supply chain vulnerabilities.

The Role of External Influences: US Under Trump

In the US, fiscal and monetary policy alignment may pose challenges. Under Donald Trump's administration, there were indications of potential upward pressure on inflation due to his policies. Simultaneously, Trump’s tendency to pressurize the Federal Reserve to lower interest rates raised concerns about maintaining the Fed’s independence. Such dynamics could complicate the US’s efforts to balance growth and inflation control.

Prospects for Interest Rate Reductions

Despite differing approaches, all three economies—US, UK, and EU—seem cautious in reducing interest rates. Central banks are wary of cutting rates too deeply, only to face renewed inflationary pressures that would necessitate reversing course. However, the wide IMR in the UK and US indicates room for adjustments.

Historically, lower interest rates have spurred equity market growth. If this trend holds, the anticipated reduction in IMR could sustain positive momentum in equity markets across these economies.