RegionsEEAECB: One cut doesn’t necessarily make for a starting gun

ECB: One cut doesn’t necessarily make for a starting gun

Online news outlets and social media channels were all a flutter last week when the Eurpean Central Bank announced it was lowering interest rates, marking a clear divergence from the path charted by the US Federal Reserve.

This decision, announced at the ECB’s recent monetary policy meeting, has raised questions about the future trajectory of central bank policies across the globe and the potential implications for the broader economic landscape.

“One cut doesn’t necessarily make for a starting gun. While the ECB became the second G7 central bank to cut rates, it is by no means certain that it will follow through with more than one cuts this year,” says George Lagarias, chief economist/investment strategist at Forvis Mazars.

Understanding the ECB Rate Cut Implications

The ECB’s Governing Council cited several key factors that contributed to their decision to reduce the key interest rate by 25 basis points, bringing it down to 3.75%.

Chief among these was their updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission within the Eurozone.

“Based on an updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady,” the Governing Council stated in its official policy statement.

The council noted that since its September 2023 meeting, inflation in the Eurozone had fallen by more than 2.5 percentage points, and the overall inflation outlook had improved markedly.

Underlying inflation had also eased, reinforcing the signs that price pressures were weakening, and inflation expectations had declined across all time horizons.

“While prices of goods have been lower, services inflation remains sticky,” says Lagarias. “We are at a point where China is deliberately lowering export prices to capture market share. One way or another, this practice has a time limit. If services inflation hasn’t come down by then, Europe could find itself having to raise rates again.”

Janet Mui, head of market analysis at Brewer Dolphin also noted that the ECB will likely be cautious from here on out.

“Inflation has re-accelerated recently and activity data has been surprisingly positive, the ECB will likely avoid committing to specific time frame of cutting rates,” she said. “Forward guidance remains broadly unchanged as per the policy statement as it will continue to follow a data-dependent and meeting by meeting approach.”

Diverging from the Fed’s Approach

The ECB’s decision to cut rates stands in stark contrast to the approach taken by the US Federal Reserve, which has maintained its stance of leaving interest rates unchanged at its most recent policy meeting.

This divergence in monetary policy has led analysts to suggest that the world’s major central banks are entering a new regime, one characterised by a lack of synchronisation in their efforts to manage inflation.

“We are at the beginning of a new regime in central banks, as many major central banks start to ease policy ahead of a very timid Fed,” James Rossiter, head of global macro strategy at TD Securities, observed.

The ECB’s move also puts it ahead of the Federal Reserve in the current cycle of rate reductions, a position that could have significant implications for the global financial landscape.

Cautious Optimism and Persistent Challenges

Despite the ECB’s decision to ease monetary policy, the Governing Council remains cautious in its outlook, acknowledging that domestic price pressures within the Eurozone remain strong. Wage growth is elevated, and the council expects inflation to stay above the 2% target well into next year.

“At the same time, despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year,” the Governing Council stated.

This nuanced approach is reflected in the ECB’s updated macroeconomic projections, which have been revised upward for both headline and core inflation in 2024 and 2025 compared to the March forecasts.

The staff now anticipate headline inflation to average 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026, while core inflation is expected to average 2.8% in 2024, 2.2% in 2025, and 2.0% in 2026.

“It was not that long ago that markets were doubting the ability and/or willingness to move ahead of the Fed,” said Jeremie Peloso, macro strategist at BCA Research.

“So, what now? The pace of ECB rate cuts will not be hindered by negative inflation surprises. Sure, year on year core inflation rebounded. However, this is nothing more than a small bump on the road to target.”

A Data-Dependent and Meeting-by-Meeting Approach

The ECB has made it clear that its future decisions on interest rates will be driven by a data-dependent, meeting-by-meeting approach, rather than a pre-committed path. The Governing Council emphasized that its interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.

“We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction,” the council stated.

“In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission.”

This stance suggests that the ECB is willing to remain flexible and responsive to evolving economic conditions, rather than adhering to a predetermined course of action.

What Does the ECB Rate Cut Mean for Investors?

The ECB’s rate cut is expected to have a tangible impact on various sectors of the Eurozone economy. For homeowners with mortgages, the move could translate into slightly lower repayment costs, providing some relief amidst the broader economic landscape.

On the other hand, savers may see a dip in the interest rates offered on their deposits, as financial institutions adjust their offerings in response to the central bank’s policy change.

Businesses, however, are likely to view the rate cut positively, as it will result in a reduction in borrowing costs, potentially stimulating investment and economic activity.

“Lagarde said previously that the ECB was watching three key indicators that influence services prices: wages, productivity, and margins,” explains Natasha May, global Market Analyst at JP Morgan Asset Management

“Wage growth is still high, but slowing – the ECB expects this slowing to continue, which should help ease labour-intensive services inflation. Productivity actually contracted last year, but was flat in the first quarter of 2024 – the ECB is hoping this picks up further, as stronger productivity helps offset high wage growth.”

“And corporate margins are likely decelerating – good news for the ECB, who anticipated firms would absorb more wage increases as their pricing power declined.

Given this picture, May says the ECB is likely feeling “more comfortable” that services prices should slow going forward. “President Lagarde thus hinted that we could see further, gradual rate cuts this year,” she said.

The Potential for Further Easing

While the ECB’s decision to cut rates has been widely anticipated, questions remain about the potential for further easing in the future. Some analysts believe that the central bank may be cautious about embarking on a prolonged cycle of rate reductions, given the persistent inflationary pressures within the Eurozone.

“The ECB is drawing a clear distinction: The next few decisions are about dialling back, not necessarily starting a proper cutting cycle,” economists at Bank of America noted in a recent report.

However, other experts suggest that the ECB may have more room to manoeuvre, particularly if the economic conditions within the Eurozone continue to improve and inflationary pressures ease further.

“Although I think that there would be justification, indeed, to continue with cuts until the end of the year, because wages have been decelerating, the economy is still very weak when compared with the United States,” said Vitor Constâncio, the ECB’s former vice president, in a recent interview.

Navigating the Divergence with the Fed

The divergence between the ECB and the Federal Reserve in their respective monetary policy stances has raised concerns about the potential for global spillover effects.

Central banks in major economies are typically cautious about straying too far from the policies of their peers, as significant divergence can lead to currency fluctuations and other disruptive market dynamics.

“There’s no sort of bright line, and you can see from history there have been periods of considerable divergence,” Tiff Macklem, the governor of the Bank of Canada, acknowledged in a press conference following his own central bank’s decision to cut rates.

The ECB has indicated that it will closely monitor the impact of its policy decisions on the broader financial system, and it stands ready to adjust its instruments as necessary to ensure the smooth functioning of monetary policy transmission across the Eurozone.

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