The trans-Atlantic interest rate divergence

Ethan Ilzetzki and Marta Grzana

Thursday, March 20, 2025

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Summary

A majority of the CfM-CEPR panel attributes the divergence of US and EU interest rates to the long-term differences in growth expectations and the natural rate of interest. Around a third of the panel attributes the gap to diverging inflation expectations and fiscal policies.

 

Background

The March 2025 CfM-CEPR survey asked the panel for the causes of the interest rate divergence between the US and Europe.

 

Interest rate divergence

Interest rates have diverged between the US and Europe over the past decade (Figure 1). In contrast, interest rates in the US and UK have moved more or less lock-step. Why have Eurozone interest rates diverged from the US? And why have UK rates not? European interest rates increased in recent days, following the German announcement on increased defense and infrastructure spending, but a gap of over a percentage point remains. There are several potential explanations for the recent interest rate divergence between the US and the UK, on one hand, and the Eurozone, on the other.

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Figure 1: 10-year interest rates in Germany and the US

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Source: Board of Governors of the Federal Reserve System and the OECD, from fred.stlouisfed.org, Feb 16, 2025

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Historically, trans-Atlantic monetary policy divergence was driven by differences in economic activity, prompting differences in monetary policy stance (2004 and 2016). Since 2022, ECB rates have risen less rapidly than US rates, with a gap of more than 1 percentage point in the two regions’ monetary policy rates (Figure 2). In contrast, the Bank of England has stayed in lock-step with the Federal Reserve in its monetary policy rates (Giles, 2024). Furthermore, the ECB began loosening monetary policy earlier than its Anglophone counterparts. These may reflect differences in views on inflationary pressures. In addition, the US economy is less sensitive to higher interest rates than other economies, requiring the central bank to raise rates more aggressively in face of inflationary pressures (Wilding & Balls, 2024).

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Figure 2: Monetary policy interest rates of the Bank of England, ECB, and Federal Reserve

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​Source: S&P Capital IQ data, 26th February 2025​

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The divergence in monetary policy stances may reflect differences in underlying economic conditions. Since the pandemic, GDP growth has been higher in the US than in the UK and the Eurozone: in January, the German economic growth forecast was downgraded to 0.3% from October’s 1.1% estimate (Armstrong, 2025). This comes from a larger fiscal stimulus in the US, making inflation in the US more demand-driven than on the other side of the Atlantic. The US economy has also benefited more from the boom in technology companies at the forefront of the AI revolution. The Eurozone economy also has weak momentum, especially in manufacturing, combined with low consumer confidence, and gas prices that remain at a high level compared to the US: five times higher, relative to twice as high before the pandemic (Gourinchas, 2025).

A different view is that the interest rate divergence reflects differences in long term economic circumstances, and the subsequent difference in natural rates. The ECB has estimated that the Eurozone neutral rate is between 1.75 and 2.25% (Koranyi & Richardson, 2025), while the Fed estimates the US neutral rate to be at 2.9%. Vanguard has estimated that the US neutral rate has improved due to better growth prospects (Aliaga-Díaz, 2024). A higher US rate reflects persistent stronger productivity growth, especially in the technology sector, supported by deeper capital markets and a more favorable business environment. In the long-term, this structural advantage contributes to higher returns on US investments and increased capital flows which translate into a stronger US dollar (Gourinchas, 2025). On the other hand, the Eurozone natural rate of interest is driven down by demographic factors, such as the aging population resulting in slower labour force growth (IMF, 2023). Moreover, according to Citibank, in the third quarter of 2024, non-residential investment rose to 17% more than the pre-pandemic level in the US, while only 8% higher in the UK, and over 8% lower in the Eurozone (Giles, 2025). Simultaneously, the effects of tighter monetary policy are more muted in the US than in Europe, partly due to differences in the mortgage market structure: the 2022 energy crisis had a larger impact in Europe, leading to weaker household balance sheets (Goldman Sachs, 2024).

 

Another reason for monetary policy divergence is the difference in fiscal policy and public debt levels, amplified by uncertain trade policy. US Federal Debt stands at 120% of GDP, compared to 95% in the UK, and 88% in the Euro Area. Bianchi, Faccini and Melosi (2023) attribute much of the recent inflationary surge in the US to US fiscal policy and Barro and Bianchi (2023) show that inflation differences across OECD countries can be attributed to public debt levels. Yet the gap between inflation protected-US and German bonds is roughly the same as that of the nominal bonds, indicating differences in real interest rates, not merely inflation expectations. Meanwhile, Trump’s economic policy changes may be amplifying the anticipated divergence. The US Congress is currently proposing tax cuts that aren’t fully funded by spending cuts, while Europe was running tighter budgetary policy (until the German budgetary announcement), and the UK intent on adhering to its fiscal rules. Additionally, Trump’s increased tariffs may cause a domestic supply shock, making it more difficult for the Fed to cut rates. In contrast, tighter fiscal policy, along with a potential demand shock coming from the tariffs would force looser monetary policy in Europe (Giles, 2025).

 

Question 1: Which of the differences are the main cause for the medium-term interest rate differential between the US and EU countries?

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