Following the earlier lead of its Canadian and European counterparts (Switzerland and Sweden), the European Central Bank (ECB) clipped its key policy rate this week, ploughing a different furrow from the Federal Reserve.
The widely telegraphed move by the ECB marked its first cut since September 2019. Continued disinflation in the eurozone (from a peak of 10.6% in October 2022 to 2.6% in May 2024) was judged by the ECB as enough to begin easing.
The 450 basis point increase in ECB policy rates between July 2022 and September 2023 helped bring prices under better control. Energy and food disinflation have made large contributions to progress, but core price increases have halved from a peak rate of 5.7% year over year to 2.9% at present. The breadth of inflation is more moderate in the eurozone than elsewhere. About 27% of the items in the euro area’s consumer price basket have been rising by more than 4% (annualized) in the past six months, compared to 49% in the neighboring U.K. and 37% in the U.S.
There are lingering concerns over elevated wages and service prices. But forward-looking indicators such as Indeed job postings and the ECB's wage agreement tracker are all pointing towards further moderation in pay gains. Demand in the eurozone remains tepid; economic growth remains sluggish following two years of stagnation. Though activity improved in the first quarter, the divergence in performance among member states persists. A restrictive monetary policy stance is contributing to tight credit standards and weak demand for loans.
In the wake of the decision, the question arises: where will the ECB go from here? At her post-meeting press conference, President Christine Lagarde did not commit to a specific interest rate path, choosing to maintain a “data-dependent and meeting-by-meeting approach.”
THE ECB IS CONFIDENT THAT INFLATION IS HEADING TOWARDS TARGET, BUT THE LAST MILE MAY BE THE LONGEST.
After three years of high inflation, committing to a specific easing path would have heightened market expectations at a time when economic readings are surprising to the upside. Headline and core inflation numbers for May came in above consensus expectations, marking the first month-on-month acceleration of 2024. Wage gain measures remained steady or reaccelerated in the first quarter amid still-tight labor market conditions. This has raised the risk that the last mile of disinflation could take longer to run, as has been the case in the U.S. As a result, markets are pricing in only one more cut this year, down from almost six in January.
The ECB maintains it is not “Fed-dependent.” However, a growing interest rate differential with the U.S. will likely weaken the euro, tighten financial conditions and trigger capital flows to the U.S. Some ECB rate-setters have warned about diverging too much from the Fed, while others have asserted the need for a regular series of cuts to reach a neutral stance.
With disinflation in both wages and services to resume, we expect quarterly rate reductions from the ECB to start in September. Monetary policy is still restrictive: model-based estimates of the “neutral” rate of interest in the euro area are around 2.00%. We expect that end point to be reached in late 2025.
While the timing of future easing is anything but clear, the direction of travel is. Given the lingering upside risks to the inflation outlook, it is better to be cautious today than sorry tomorrow.
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