Euro struggles as higher US rates widen the policy divide

The Euro-US Dollar (EUR/USD) pair has come under pressure as the Federal Reserve's (Fed) latest interest-rate hike strengthens the US dollar and shifts attention back towards the growing difference between US and Eurozone monetary policy. The Fed raised its target range by 0.25 percentage points to 3.75%-4.00% last week and signalled that another increase could follow before the end of the year, giving the dollar renewed support.

The euro faces a more complicated backdrop. Inflation risks remain elevated across the Eurozone, particularly as higher energy prices linked to tensions in the Middle East increase costs for households and businesses. However, those same pressures can also hurt economic growth, leaving the European Central Bank (ECB) with a difficult balance between keeping inflation under control and avoiding unnecessary pressure on an already fragile economy.

Higher US rates give the Dollar an advantage

The difference between US and Eurozone interest rates remains one of the clearest drivers of EURUSD. Higher US rates can make dollar-denominated assets more attractive, particularly when markets believe the Fed could tighten policy further. The Fed's latest projections point to another quarter-point increase before year-end, while policymakers continue to highlight inflation as a major concern.

The ECB has less room to manoeuvre. Persistent inflation may prevent policymakers from becoming more supportive of growth, but another rate increase could add pressure to an economy already dealing with higher energy costs and weaker demand. This leaves the euro without the same clear interest-rate support currently benefiting the dollar.

The Eurozone's external position has also become slightly less supportive. The current-account surplus narrowed to €27.6 billion in July from €35.1 billion the previous month. While the region continues to run a surplus, the decline comes at a time when higher energy import costs are once again becoming an important concern for the European economy.

Energy risks add another challenge for the Euro

Developments in the Middle East could become increasingly important for the pair. The Eurozone relies heavily on imported energy, meaning sustained increases in oil and gas prices can push inflation higher while simultaneously reducing household spending power and raising costs for businesses. For the ECB, that creates an uncomfortable situation: inflation can rise even as economic growth slows.

The dollar can also benefit when geopolitical uncertainty increases. Its role as a safe-haven currency means periods of heightened global risk can attract demand for the greenback, adding another potential source of pressure on EURUSD alongside the widening interest-rate gap.