As was widely expected, the ECB has become one of the first major central banks (after Switzerland, Sweden and Canada) to cut interest rates this year. Despite some improvement in sentiment, sluggish economic activity since the start of 2023, coupled with broadly balanced inflationary pressures, were enough to convince the Governing Council to ease monetary policy. Based on its statement of 6 June, updated economic projections and wider ECB commentary, we still expect two further cuts this year at a quarterly pace.
The economic evidence to date supported a rate cut in June. Inflation has moderated, notwithstanding the monthly volatility. At 2.6%, HICP inflation is well below the US (3.4%) and broadly in line with the UK (2.3%). GDP growth picked up to 0.3% in 2024 Q1, better than expected but not high enough to reignite demand-led inflation, especially as it followed a technical recession in 2023 H2.
Other recent indicators have been more mixed. Core inflation bounced back to 2.9% in May, with services price inflation picking up to 4.1%, its highest level since October 2023. The latter could in part be fuelled by elevated pay growth, with growth in negotiated wages stuck at 4.7% in 2024 Q1. While the ECB pointed to one-off factors in pay settlements which drove the increase, that also comes against a backdrop of a relatively tight labour market, with the unemployment rate at its lowest level since the euro was introduced. Acknowledging these risks, ECB Chief Economist Philip Lane previously stressed that the rate cut should not be interpreted as a declaration of victory on inflation.
Nonetheless, the Eurozone economy is in a different place than the US, which is subject to a resurgence in inflation and a looser fiscal stance. The cost-of[1]living crisis left a larger dent on household real incomes in Europe, whereas in the US domestic demand is strong. In addition, a tighter policy by the US Federal Reserve could provide additional tightening in global financial conditions including via boosting long-term European bond yields, potentially warranting a greater policy offset at the short end of the curve.
The pace at which the ECB proceeds with further cuts will be contingent on whether it sees a risk of a re-acceleration in inflation. The latest forecast shows that inflation has been nudged up both this year and next and only returning to target in 2025 Q4. The outlook for GDP was also revised up for 2024 on the back of stronger Q1 data.
President Lagarde was cautious today in her guidance on the future path of monetary policy. She highlighted the meeting-by-meeting approach to interest rate decisions, likely retaining policy flexibility in the face of upside risks to inflation and potential disagreement on the Governing Council.
The rhetoric coming from other Governing Council members underscores a lack of consensus on the frequency of future rate cuts. Isabel Schnabel, Member of the Executive Board, said that “based on current data, a rate cut in July does not seem warranted”, warning that front-loading cuts could come with a risk of premature easing. Set against that, Yannis Stournaras, Governor of the Bank of Greece, revealed that they “now consider the three interest rate cuts in 2024 as the most likely scenario”, while Klaas Knot of the Dutch central bank noted that “the optimal policy would have been broadly in line with three to four rate cuts” this year.
Despite the relatively hawkish backdrop, we still expect the ECB to ease twice more this year, at its September and December meetings. Financial markets currently put only a 17% probability on a cut in July, with two cuts not fully priced in by the end of the year. Combined with the ECB’s estimate of the equilibrium level of just above 2%, this would keep policy in a restrictive territory for a considerable period. We think this should provide enough breathing room to maintain an easing bias at the ECB over the remainder of this year and into 2025.
