The European Central Bank on Thursday confirmed a reduction in interest rates — despite lingering inflationary pressures in the euro zone.
The move takes the central bank’s key rate to 3.75%, down from a record 4%.
“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 ECB Governing Council said in a statement.
“Since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly.
“Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons.
“Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down.
“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 latest Eurosystem staff projections for both headline and core inflation have been revised up for 2024 and 2025 compared with the March projections.
“Staff now see headline inflation averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. For inflation excluding energy and food, staff project an average of 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026.
“Economic growth is expected to pick up to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026.”
REACTION:
Felix Feather, Economist, Abrdn: “The European Central Bank (ECB) today became the first major developed market central bank to cut interest rates since the global wave of hikes across 2022-23.
“The move came as no surprise to economists’ expectations or financial markets as the decision had been strongly signalled in the communications of the Governing Council since its last monetary policy meeting in April.
“With one cut under its belt, attention now turns to prospects for further cuts over coming meetings.
“On this front, officials are remaining no-committal, stressing data-dependence and flexibility. Indeed, the monetary policy decision statement was clear: “[t]he Governing Council is not pre-committing to a particular rate path.”
“In practice, a data-dependent approach is likely to be a cautious one. Scant additional data will be available to the ECB before its July meeting. In particular, no hard wage growth data for Q2 will be available. We therefore consider the re-doubled stress on data dependence to be consistent with our call for the deposit rate to be held at 3.75% in July.”
Lindsay James, investment strategist at Quilter Investors: “The starting gun has been fired and the European Central Bank is the first out of the major three banks to start cutting rates. This is a significant move given it is the first rate cut from the ECB in five years, and ends what has been one of the most aggressive and swift rate hiking cycles in modern times.
“Importantly, this is not likely to be a single cut and done for a while, with signals suggesting a further cut or two are on the horizon this year as inflation has subsided. The ECB has stolen a march on the Bank of England and Federal Reserve – who are both potentially still a few months away from cutting – and will breathe life into an economy that desperately needs some form of stimulus.
“While this news was well expected, it will no doubt provide relief to consumers and businesses on the continent. Ever since Russia’s invasion of Ukraine, Europe has struggled to combat the economic shock this produced, but signs are now improving, although uneven across the continent. While inflation has ticked up in recent months, the economic recovery is beginning to play out. This puts the ECB in a good position to cut further into a slowly improving picture, although the messaging is likely to remain restrained and cautious. As such, there may be some pauses on the way back down for rates in order to limit the scope of any divergence with the Federal Reserve.
“This move also focuses eyes on the BoE, who will make its decision in a couple of weeks. The major central banks will not want to diverge too far from one another, and with political risk being ratcheted up, they also won’t want to be seen as too influential.”
Susannah Streeter, head of money and markets, Hargreaves Lansdown: “The European Central Bank has, as widely predicted, cut the eurozone’s key interest rate to 3.75%, moving faster than the Bank of England and the Federal Reserve.
“The reduction will come as a relief for many consumers and companies, whose finances have been stretched to breaking point by the rapid ratcheting up of interest rates. But ECB policymakers are expected to hit the pause button now, as sticky inflation has returned as a worry. While rates went straight up like a rocket, they look likely to descend in bumpy fashion.
“Financial markets have been pricing in two to three rate cuts in total by the ECB by the end of the year, but it’s looking unlikely that that policymakers will vote for another move lower next month. Caution is set to stay the name of the game, as they await fresh indications about inflation’s path. Headline inflation went in the wrong direction at the last count, heading away from the ECB’s 2% target. It rose by 2.6% year-on-year in May, compared to 2.4% for the previous two months, a larger increase than expected. Prices in the services sector, seen as a good indicator of domestic demand, also jumped to 4.1% from 3.7%.
“However, the overall direction of travel is clear – and it’s downwards. The ECB decision will raise hopes that UK interest rates will also be brought down sooner rather than later. The data coming in over the past few days has been more positive for the Bank of England, indicating that price pressures are easing. So an interest rate cut in August is still a very real possibility, although the financial markets have not been fully pricing in a cut until November …
“The Eurozone is in the recovery stage, with growth rising by 0.3% in the first three months of the year, after six quarters of stagnation or contraction. Unlike previous economic rough patches, firms have retained workers – with unemployment now at an all-time low. This means that stubborn pay growth remains a concern for policymakers, following a rise in negotiated salaries. There are concerns that it could feed further into higher prices, which is why policymakers are expected to stay more cautious in the months ahead.
“If higher borrowing costs persist, this is set to have a further knock-on effect on the bloc’s economy, which is only just on the mend. Unemployment is forecast to rise, which may help ease pay pressures, but could cause a fresh weakening in economic activity. Even if interest rates creep down again later this year, as expected, it may not stop further problems for the commercial property sector, given the jump in refinancing costs that many firms will still be facing.
“The International Monetary Fund has warned that Europe’s lacklustre growth prospects risk causing economic instability. On the face of it, European economies are constrained by growing deficits and strict rules on borrowing, which makes it difficult to spend big to boost fragile economies.
“This is especially the case given the demands on budgets from increased military spending and the need to support the green transition to meet agreed targets. Eleven countries, including France, Italy and Belgium, had deficits last year above 3% of GDP, the official high limit for debt. But there may be some room for manoeuvre given new rules that give a four-year grace period, with an option of extending to seven years – if governments show they are making investments aimed at boosting growth in the economy.’’