US Fed's Aggressive Rate Hikes Add Pressure on European Economy

A stronger U.S. dollar arising from the Federal Reserve's aggressive interest rate hikes has intensified pressure on the European economy, leading to higher inflation and energy costs.

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"The Fed has increased interest rates much more aggressively than the European Central Bank (ECB). This will likely lead to a further weakening of the euro to the dollar," said Philipp Lausberg, a policy analyst at the think-tank European Policy Centre.

As the Fed has pulled its key overnight interest rate to a range of 3 percent to 3.25 percent, compared with around 1 percent for the ECB, it will be more attractive to hold savings denominated in dollars rather than euros.

This will likely continue to drive investors to switch from euros to dollars, leading to a further devaluation of the euro, Lausberg said, pointing out that a stronger dollar will make imports to the EU more expensive, resulting in a higher inflation rate, which could lead to tighter lending conditions.

"Prices for crucial raw materials, which are denominated in dollars and of which the EU imports a large share, will rise. This would concern resources such as oil, gas, rare earths, and metals, but also other components which are part of global value chains the EU economy depends on. As a consequence, inflation could further rise," he explained.

Altogether, a contractionary U.S. monetary policy poses significant risks to the EU economy and its financial system. While European banks are relatively resilient, very high fed interest rates come to endanger financial stability in the EU.

Meanwhile, the current high cost of energy forced the European trade deficit to go from "being a consistent surplus to a persistent trade deficit," said James Knightley, ING Chief International Economist.

The EU's growth outlook remains gloomy given the strains that high natural gas and electricity prices are putting on households and businesses in European countries.

Consequently, the dollar is getting a lift from interest rates and the structural change in Europe's trade position that has had a major impact on foreign exchange market, he said, adding that outside of Europe, the effects of the U.S. Fed rate hike are also felt.

"Japan has already intervened and there is talk that the bank of England may have to do something to stem the slide in sterling. Basically we are back to the famous quote by U.S. Treasury Secretary John Connally from the 1971 G10 Finance Ministers' meeting -- 'the dollar is our currency, but it's your problem,'" said Knightley.