Treasury

European inflation has surprised everyone—and it could help its long-struggling economy catch up with the U.S.

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· 5 min read

It’s long felt like a fact of life that the U.S. economy outperforms Europe’s. The divergence has become more pronounced of late, as America’s biggest industries seem to have gotten the jump on major technological advancements such as AI.

Across the water, Europe’s biggest economy Germany has been stuck in a rut, while the continent’s workers have faced accusations of simply not being ambitious enough to keep up with their U.S. peers.

But Europe bulls might finally be rewarded for their patience, as a growing number of analysts are betting on the EU closing the gap.

Unexpected good news

Rajeev Sibal, a global economist with Morgan Stanley, said the bank’s expectation was for the EU economy to accelerate this year.

And after months of grim growth, export and production figures in its biggest economies, the continent could be in for some much needed good news on the monetary policy front.

Eurozone inflation fell to 2.4% in March, with expectations of a similar level in April. In the U.S., meanwhile, prices grew at 3.5%, well above both central banks’ targets of 2%.

Europe has accordingly been able to go bolder with its monetary policy in comparison with the U.S. Last week, Sweden’s Riksbank became the latest European central bank to cut interest rates, with the view that it could grow its economy without stoking inflation.

It was the first time this century the Swedish Central Bank had moved ahead of the Fed to cut interest rates.

“In the euro area, one of the reasons we have this divergence between the Fed and the ECB is because Euro area inflation is more clearly trending lower and closer to target,” Sibal said. “And I think that trend in the Euro area affects the decision-making of many central banks in the region.”

A tight labor market in the U.S., on the other hand, makes it harder for policymakers to lower rates.

The lag effect of that restrictive monetary policythe Federal Funds rate has been stuck at a more than 23-year high since last summeris starting to affect the resilient American shopper.

Sibal indicated that the long-running divergence between the U.S. and Europe was set to close in the second half of 2024 as the EU becomes more competitive.

“We expect that the US consumer and labor market will start to show further signs of deceleration,” Sibal said. Euro area consumers, on the other hand, “are seeing a pick up in real incomes as inflation cools, which is supportive for private consumption.”

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The U.S. is still expected to outpace Europe this year, growing at 2.6% compared with the Eurozone’s 0.7%, according to the OECD. But a monetary policy divergence is drastically changing the rules of engagement.

Swiss bank UBS is even more bullish on Europe’s chances of outperforming the U.S. In a note last week, UBS Investment Bank strategist Andrew Garthwaite said that based on the indicators it trackedincluding PMI data, excess savings, and monetary policyEurope GDP carried upside risks, meaning it was more likely to outperform growth expectations.

The bank says the U.S., meanwhile, carries downside risks.

As a result, UBS decided to make a U-turn, with European stocks (excluding the U.K.) outranking American stocks on its regional scorecard.

It echoes Goldman Sachs’ bullish bet back in March on a group of European stocks titled the ‘Granolas’, which the bank touted as being able to take on the much-vaunted “Magnificent 7” U.S. stocks.

Problems remain

Despite signs that Europe will start converging with the U.S. in the second half of the year, there are still many familiar obstacles that may prevent it catching up.

One of those is overcoming a widening productivity gap between the two regions.

European productivity, or output per worker, has been lagging the U.S. for some time, but has really fallen behind since the onset of the global financial crisis of 2007-2008.

Erik Thedéen, the man who oversaw Sweden’s ambitious rate cut, acknowledged that Europe needed to improve its productivity levels to catch up with the U.S.

There are several factors that could have contributed to this gap, with some academics blaming Europe’s failure to invest in the knowledge economy in the 1990s.

In a U.S.-focused analysis, Morgan Stanley said the proliferation of AI and a tight labor market had been boons to U.S. productivity in recent years too. It didn’t carry out a comparative analysis with Europe, though.

But underlying the productivity debate is the controversial perception that Europeans simply don’t work as hard as Americans.

Speaking to the Financial Times in April, Nicolai Tangen, the CEO of Norway’s $1.6 trillion oil fund, said there was a difference in the “general level of ambition” between Europeans and Americans.

“We are not very ambitious. I should be careful about talking about work-life balance, but the Americans just work harder,” Tangen said.

Whatever that perception, Europe can bask in a warm feeling this summer, knowing that for once they may not be the world’s economic underperformer.

Read more on Fortune.

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CFO Brew helps finance pros navigate their roles with insights into risk management, compliance, and strategy through our newsletter, virtual events, and digital guides.