Cutting U.S. interest rates would give the European economy room to breathe

Snapshot for June 25, 2003.

Cutting U.S. interest rates would give the European economy room to breathe
The Fed will likely cut interest rates today at its regular Federal Open Market Committee meeting. While some economists have questioned the logic of more interest rate cuts, there are good reasons for the Fed to cut rates further.

Aside from the fact that further reductions in interest rates by the Fed will help keep mortgage rates low and the domestic housing market humming, there is also an important international component to the Fed's interest rate decision. In particular, as interest rates in the United States decline, other central banks-especially the European Central Bank (ECB)-have more leeway to reduce their own rates. In recent months the inflation-adjusted difference between European and American interest rates has shrunk (see figure). This means that the ECB would have a hard time reducing rates further without fearing capital outflows as investors looked for higher returns elsewhere. However, if the United States takes the lead and reduces its rate now, there will be room for the ECB to reduce its own key interest rates, thereby giving the sluggish European economies a boost.

Why should U.S. policy makers care about growth in Europe? The fact is that Europe remains an important trading partner for the United States, and the U.S. trade deficit is still at dangerously high levels. Faster economic growth in Europe would help to increase exports to Europe, thus aiding producers in the United States, especially in the struggling manufacturing sector. As U.S. exports rise, the economy and the labor market should follow suit.

Source: European Central Bank (www.ecb.de) and the Board of Governors of the Federal Reserve System (www.federalreserve.gov).

This week's snapshot was written by Christian E. Weller.

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