The European Central Bank is expected to cut interest rates at its June 6 meeting, as widely signalled in recent weeks by its policymakers.
The interest rate on the main refinancing operations, the marginal lending facility, and the deposit facility are anticipated to drop by 25 basis points to 4.25%, 4.50%, and 3.75%, respectively.
This will mark the first cut since March 2016 for both the main refinancing operations rate and the marginal lending rate while, for the deposit rate, it will be the first reduction since September 2019.
Why is the ECB cutting interest rates?
The overall increase of 450 basis points implemented by Frankfurt between July 2022 and September 2023 has contributed to bringing down the headline inflation rate in the eurozone from a peak of 10.6% in October 2022 to 2.6% in May 2024.
President Christine Lagarde indicated in March that more clarity and sufficient data would be available by June. It appears that moment has arrived.
While inflation has not yet completely met the 2% target, its substantial decrease signals a continuing downward trend expected to persist in the coming months.
According to the latest ECB projections from March 2024, the average inflation rate is expected to decrease to 2% in 2025 and 1.9% in 2026. As for core inflation, which excludes energy and food prices, projections see it at 2.1% for 2025 and 2.0% for 2026.
The 25 basis points cut would also continue to maintain positive real interest rates, as nominal rates will remain above the current inflation rate. Thus, it will indicate a reduction in the degree of monetary policy restrictiveness, rather than a broader normalisation.
The rising and elevated cost of borrowing has created a slowdown in the bloc's economic growth, containing demand to put a brake on price pressures.
While the euro area's economy expanded by 0.3% in the first quarter of 2024, the preceding two quarters were both marked by 0.1% contractions. The second quarter of 2023 saw a minor 0.1% growth, and the first quarter of 2023 and the last of 2022 saw stagnation.
Will the ECB continue to cut rates after June?
Despite the widely anticipated rate cut in June, recent remarks from ECB officials suggest that there will be no pre-commitment to future cuts afterward.
This means that a further rate cut in July remains uncertain, as the ECB aims to retain flexibility in its decisions and continue monitoring economic data.
Eurozone inflation edged higher in May, reaching 2.6%, above the expected 2.5%, while core inflation rose to 2.9% from 2.7% in April.
We expect President Lagarde to signal once again that more information will be available in July to guide the next decision, with even greater clarity expected by September.
The new June economic projections might suggest a slight upward adjustment in economic growth and inflation for 2024, while maintaining the 2% inflation forecast for 2025 unchanged.
Money markets are currently pricing in 43 basis points of ECB cuts by September and approximately 60 by the end of the year. Thus, market expectations are caught between predicting two to three ECB rate cuts in 2024.
What are the risks of cutting rates too much or too little?
The ECB faces the challenge of balancing the risks of cutting rates too much against those of cutting too little.
If Frankfurt eases monetary policy too quickly and significantly, it would likely boost consumer demand and investment. However, this could also risk rekindling inflationary pressures before the 2% target is fully achieved.
The ECB would expose itself to uncertainties related to energy prices and geopolitical tensions with reduced buffers, potentially leading to undesirable effects on price dynamics.
Furthermore, while President Christine Lagarde stressed that the ECB is "data-dependent and not Fed-dependent", divergence between the policies of the world's two major central banks could have significant financial impacts, especially on exchange rates.
Aggressive rate cuts by the ECB while the Fed maintains higher-for-longer interest rates would put strong downward pressure on the euro against the dollar, risking further upward price pressure on imported goods and services.
Conversely, if Frankfurt maintains a restrictive monetary policy for too long and cuts rates less than the market currently expects, it risks choking economic growth in the eurozone and widening the gap with the United States.
Therefore, it is highly likely that the ECB will opt for a middle ground, announcing a rate cut in June and maintaining a data-dependent and meeting-by-meeting approach for subsequent adjustments.
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