Euro/USD faces a critical moment as divergence in ECB and BOE policies drives a shift in the currency market

At the beginning of this month, the European Central Bank and the Bank of England announced their interest rate decisions in succession. The divergence in their policy stances has heightened market focus on the direction of EUR/USD. The ECB chose to keep policy unchanged, while the BOE faces a more significant policy dilemma regarding rate cuts. This divergence is profoundly impacting the global currency market landscape.

ECB Holds Steady, EUR/USD Appreciation Becomes New Policy Focus

The European Central Bank decided to maintain the deposit facility rate at 2%. Currently, inflation in the Eurozone has fallen to 1.9%, below the ECB’s 2% target, supporting long-term policy stability. Since June last year, the ECB has kept rates unchanged for over six months, with markets generally believing its rate cut cycle has ended.

However, market attention is shifting to exchange rates. Recently, the euro has appreciated significantly against the dollar, but this appreciation is not driven by improvements in the eurozone’s economic fundamentals. Instead, it reflects investor expectations of declining attractiveness of U.S. assets. Evercore ISI analysts suggest that ECB President Lagarde may address this topic in the upcoming policy statement.

The key issue is that excessive euro appreciation could suppress inflation. If the euro strengthens further, import costs will decline, exerting downward pressure on inflation. Steven Barrow, head of G-10 currency strategy at Standard Chartered, notes that if EUR/USD breaks above the psychological level of 1.25, the decline in inflation could surpass ECB expectations, potentially forcing the ECB to resume rate cuts. However, for this to happen, the euro would need to rise to the 1.25–1.30 range against the dollar, which requires relatively stringent conditions amid weakening demand.

BOE Faces Dilemma, Market Focus on Timing of Rate Cuts

Compared to the ECB’s stance of holding steady, the Bank of England faces a more complex situation. The BOE’s decision-makers largely agree that further rate cuts are needed this year, but disagreements remain over the timing.

The fundamental reason for this divergence is that UK inflation is more severe. In December, UK inflation rose to 3.4%, the highest among G7 countries, well above the BOE’s 2% target. Although the bank expects inflation to fall back toward the target around mid-year, the current high inflation continues to constrain policy options. Additionally, uncertainty over wage adjustments in 2026 raises concerns about a potential inflation rebound.

Oxford Economics economist Edward Allenby states that most BOE members see the April 2024 meeting as the most likely timing for the next rate cut. However, market expectations are more cautious. Mitsubishi UFJ Bank analyst Lee Hardman believes the BOE may need to wait until the May policy meeting to implement further cuts. This delay in rate cut expectations is supporting the pound’s strength.

How Diverging Central Bank Policies Drive EUR/USD Movements

The policy divergence between the ECB and the BOE ultimately influences the market through exchange rate mechanisms. Expectations of delayed rate cuts by the BOE enhance the relative attractiveness of the pound, while the euro faces upward pressure, indicating limited policy space for the ECB. These factors together make EUR/USD one of the most watched currency pairs in the global forex market.

From a broader macro perspective, the interaction between central bank policies and exchange rates creates a feedback loop: currency appreciation constrains inflation, low inflation fuels rate cut expectations, which in turn further depress the exchange rate. In this cycle, EUR/USD’s performance will directly reflect the growth outlooks and capital flows of the two major economies. Over the coming months, fluctuations in this pair will serve as an important window into global risk appetite.