The ECB as a bellwether for the Fed

It is Fed day, again, and you might wonder what surprises the Fed has in store for us this time. Are they going to hike rates, do nothing, or even cut rates? As it turns out, you may want to look at the decision of the ECB last week to get an idea in which direction the Fed may go.

I, and many other investors as well, sometimes get the feeling the ECB and the Fed coordinate their policy decisions. It sometimes seems as if the Fed is mirroring the ECB moves and vice versa. I don’t think it is a conspiracy where someone in Frankfurt is picking up the phone to talk to someone in Washington. Instead, I think the economies of the US and Europe have increasingly become synchronised in a globalised world, so the two central banks face similar problems and react to them in a similar fashion. It’s what you would expect in a committee that is driven by data and analysis.

Andrew Kane and his colleagues have found that such a linkage does indeed exist. They looked at the policy surprises by the ECB and whether these policy surprises were able to predict similar surprises by the Fed in subsequent meetings. The chart below shows that if the ECB provides a 1 percentage point policy surprise compared to consensus expectations for rates, that typically translates into a 0.25 percentage point policy surprise by the Fed.

As far as I know, the ECB has never surprised markets with a move in interest rates more than 1 percentage point away from expectations (except maybe during the GFC), but the idea is clear: If the ECB is surprisingly hawkish, chances are the Fed will be too.

Fed and asset market surprises after an ECB policy surprise

Source: Kane et al. (2023)

And you can see that in government bond yields and stock markets as well. On the day of a Fed meeting yields on Treasuries and German Bunds tend to have surprise jumps in yields after the ECB provided a policy surprise a couple of days before. Similarly, stock markets drop a little in reaction to hawkish policy surprises by the ECB even a couple of days later when the Fed announces its policy decisions. Whether that is in reaction to the Fed decision or the ECB decision or both is impossible to tell, but it indicates that the decisions of the ECB do have repercussions not just on the day of the ECB decision but indirectly a week or so later when the Fed meets.