When the Federal Reserve "lowers interest rates alone," while other central banks even begin to raise rates, the depreciation of the US dollar will become the focus in 2026

The divergence in global central bank policies is accelerating. While the Federal Reserve continues its path of interest rate cuts, central banks in Europe, Canada, Japan, Australia, and New Zealand generally maintain a tightening stance and have even entered a rate hike phase. The divergence in monetary policy is expected to have a significant impact on the exchange rate market by 2026, with the depreciation pressure on the dollar becoming a market focus and potentially a key external variable influencing the European Central Bank's policy direction.

On Wednesday local time, the Federal Reserve cut interest rates by 25 basis points as expected. Goldman Sachs analyst Rich Privorotsky's latest research report points out that despite the market's hawkish expectations due to Powell's cautious remarks on neutral interest rates and several dissenting votes at the meeting, this decision actually conveys a dovish tone.

In stark contrast, European Central Bank officials have clearly stated that they will not closely monitor the Federal Reserve's rate cuts. The Governor of the Bank of France, François Villeroy de Galhau, recently stated, "It is a misunderstanding to think that the European Central Bank will follow the Federal Reserve step by step," and pointed out that "the monetary policy stance in Europe is already more accommodative than that of the United States."

The core impact of policy divergence is expected to manifest through the exchange rate channel. Goldman Sachs emphasizes that if the Federal Reserve continues to cut rates while other major central banks maintain a tightening stance, market attention will focus on the potential sustained depreciation pressure on the dollar.

Market Consensus on Fed Rate Cuts Next Year

Major Wall Street investment banks maintain expectations for further Fed rate cuts after the decision. The Morgan Stanley and Citigroup predict another rate cut in January, judging that the easing cycle has not yet ended. Goldman Sachs and Barclays analyze that the hawkish wording in the policy statement aims to "balance" this rate cut and avoid sending an overly accommodative signal.

Citigroup, Morgan Stanley, and JP Morgan all point to January as the timing for the first rate cut, with Citigroup expecting another cut in March, Morgan Stanley predicting a second cut in April, and JP Morgan believing that the policy will enter an observation period thereafter.

Goldman Sachs, Wells Fargo, and Barclays expect the rate cut window to open in March, with a possible second cut in June.

Will Dollar Depreciation Force the ECB to Cut Rates?

Several European Central Bank officials have been vocal around the time of the Federal Reserve's December meeting, emphasizing their monetary policy independence. The Governor of the Bank of France, François Villeroy de Galhau, stated last Friday that the European Central Bank should keep the option to cut rates, but "should not abandon its own policy pace due to the actions of the Federal Reserve."

Isabel Schnabel, a member of the ECB's Executive Board, further pointed out in an interview: "Changes in the U.S. monetary policy stance will not have a direct impact on the European Central Bank. We independently formulate policies based on data and analysis from the Eurozone." She even suggested that there is a possibility of a rate hike in the ECB's next move.

The divergence in monetary policies between Europe and the U.S. is not a new phenomenon. In mid-2024, the European Central Bank began its rate cut cycle earlier than the Federal Reserve, which maintained its rates at that time. Villeroy noted, "Despite the differences in policy pace, the foreign exchange market has absorbed this situation without significant volatility, and similar situations have occurred multiple times over the past decade." The European Central Bank's likelihood of following the Federal Reserve in cutting interest rates in the short term is relatively low. Currently, the Federal Reserve has lowered its interest rate range to 3.5%-3.75%, while the European Central Bank's key rate has been at 2% since its cut in June, indicating structural differences in policy space and inflation situations between the two.

Although the European Central Bank repeatedly emphasizes its monetary policy independence, the actual transmission effects of exchange rate fluctuations may, in fact, dominate its policy direction. Since 2025, the euro has appreciated by about 12% against the dollar, and this change is imposing substantial constraints on the ECB's decision-making through the inflation channel.

Philip Lane, the chief economist of the European Central Bank, recently pointed out that exchange rates have a significant transmission effect on inflation. According to the bank's internal model calculations, a 10% appreciation of the euro will suppress inflation over three years, with the most significant impact occurring in the first year, during which the rate of price increases will be 0.6 percentage points slower than in other scenarios.

This impact is primarily transmitted through dual channels: the prices of imported goods and services decrease directly due to the appreciation of the local currency; at the same time, a stronger euro weakens export competitiveness, indirectly suppressing economic growth and upward price pressures.

It is noteworthy that the ECB's latest forecast has lowered the inflation rate for 2026 to 1.7%, below its 2% policy target. If the Federal Reserve accelerates interest rate cuts, leading to further weakening of the dollar and pushing the euro to continue appreciating, the inflation recovery path for 2027 will also face pressure. Lane has indicated that while the central bank will not react to "small, temporary" deviations in inflation, it will adjust policy in response to "large, persistent" deviations.

Currently, the ECB's forecast assumes that the euro exchange rate will remain roughly at current levels in 2026-2027. However, if the pace or magnitude of the Federal Reserve's rate cuts exceeds expectations, leading to sustained weakness of the dollar and passive appreciation of the euro, it may create new policy pressures. This essentially forms a hidden policy transmission chain: Federal Reserve rate cuts → dollar weakness → euro appreciation → further pressure on eurozone inflation → ECB may be forced to shift to rate cuts, indicating that even while maintaining independence in rhetoric, the transmission mechanism of exchange rates and inflation may still impose "factual constraints" on ECB decision-making