Lack of new data not enough to prevent a cut
The ECB moved to cut interest rates for the second consecutive meeting. While data has been limited since the previous meeting, a broad range of survey indicators are pointing to growing headwinds for the Eurozone economy, which was ultimately enough to ensure a second cut in as many months. The decision was in line with market expectations, which fully priced in the move a fortnight ahead of the meeting. We expect the ECB to cut interest rates once more this year in December and maintain the current pace of cuts in 2025, reaching a terminal rate of 2% by mid-2025.
Stalling economic activity forces ECB’s hand
Data flow was limited in the run up to the decision, mainly due to the short window since the previous meeting. Headline inflation fell below target in September, down to 1.7%. While President Lagarde had already indicated this would be the case in the September meeting, the ECB will have been encouraged by both core and services inflation easing. Nonetheless, the key driving force behind the decision to lower rates came from the Eurozone’s weakening growth outlook. The absence of updated projections meant the ECB placed more weight on a raft of survey indicators painting a weak picture of growth.
Detailed Q2 GDP data showed household savings rising to nearly 16%, its highest level since the Euro was introduced, when excluding the pandemic period. Consumer spending was down by 0.1% despite gross disposable income increasing by 0.8%, in the second quarter. This will have been a key consideration for the ECB due to the implications for domestic demand outlook. With a rebound in consumer spending unlikely to be forthcoming, September ECB growth forecasts are now potentially too optimistic. This raises the prospect of a further downgrade to growth and potentially inflation in December, providing potential room for another rate cut then.
Recent comments by ECB officials reiterated the risk to domestic demand, with Executive Board Member Frank Elderson stating “A number of recent indicators suggest that downside risks to economic growth are already materializing. We look at a broad range of data, but we have seen that households are consuming less than anticipated and firms are less keen to invest than we had projected.”
Divergent growth activity across the Eurozone continues to be pertinent. While survey data points to southern Europe maintaining its growth momentum, the German economy is facing a perfect storm of cyclical and structural headwinds. The German government recently revised down its growth estimate for this year to a contraction of 0.2%. Domestic weakness in the German economy will likely be compounded by an uncertain external environment amidst growing geopolitical tensions. In France, activity has also been sluggish with survey data pointing towards a downturn in both construction and manufacturing. Business sentiment has been hampered by a combination of policy uncertainty and fiscal challenges which are unlikely to be resolved in the near term.
Governing Council set to turn focus to growth as inflation risk recedes
The ECB stepped up the pace of monetary easing, lowering rates despite the absence of updated projections ahead of the decision. President Lagarde was tight lipped on the interest rate path going forward. Nonetheless, she stressed risks to the growth outlook remain tilted to the downside.
Isabel Schnabel, a prominent hawk in the Governing Council, supported this sentiment ahead of the decision when she stated, “We cannot ignore the headwinds to growth. With signs of softening labour demand and further progress in disinflation, a sustainable fall of inflation back to our 2% target in a timely manner is becoming more likely, despite still elevated services inflation and strong wage growth.” While both households and businesses will welcome the decision to cut interest rates further, Schnabel also emphasised monetary policy alone cannot reverse the Eurozone’s structural weakness. The Governing Council will likely have been attentive to the fact that the weakening growth outlook could be a contributing factor to inflation undershooting in the medium term and will likely want to avoid a repeat of the pre-pandemic era.
We expect the ECB to cut once more this year in December and cut in every meeting in the first half of next year. We see interest rates settling at around 2% by mid-2025.
