Andrey Yalansky
Written by Seema Shah, Chief Global Strategist
As widely expected, the European Central Bank cut key interest rates for the first time in five years. The interest rates were on the main refinancing operations, marginal lending facility, and deposit facilities Each fell by 25 basis points to 4.25%, 4.5% and 3.75%, respectively.
The European Central Bank’s decision to ease its policy restrictions comes after nine months of keeping interest rates steady. Although the decision was well thought out, the economic data received during recent weeks prompted markets to review their expectations for the policy path, reducing the number and pace of cuts in 2024.
European Central Bank President Christine Lagarde indicated on Thursday that the ECB was not in a “rollback phase,” indicating that successive interest rate cuts were unlikely, thus increasing conviction in lowering interest rate cut expectations.
Economic background
The justification for starting to cut interest rates is clear. The inflation backdrop in the euro area has improved significantly over the past year, with inflation in late 2023 falling faster than it rose and inflation expectations remaining firmly established.
However, the rationale for further interest rate cuts after June has become increasingly unclear recently. Progress on fighting inflation in the euro zone has begun to stall with the latest inflation surprise to the upside, while the European Central Bank’s index of negotiated wages rose in the first quarter, defying the central bank’s expectations of easing.
In addition, evidence of strong employment growth and cyclical economic improvement has reduced market confidence that inflation will trend lower over the coming months.
Economic forecasts
The European Central Bank published its updated forecast for average headcount for the full year. GDP growth forecasts have been revised upward for this year:
- 2024: 0.9% (upward revision from 0.6% in March)
- 2025: 1.4% (downward revision from 1.5%)
- 2026: 1.6% (unchanged)
Headline inflation expectations have been revised upward for this year and next:
- 2024: 2.5% (increase from 2.3% in March)
- 2025: 2.2% (increase from 2.0%)
- 2026: 1.9% (unchanged)
With these new forecasts, the ECB chose to cut interest rates even as it raised its inflation forecasts, even though it only expects headline inflation to reach the 2% target in 2026.
When asked about this discrepancy, Lagarde responded that although inflation expectations have been revised slightly higher, the ECB is increasingly confident that the overall trend in inflation is downward, giving them strong conviction in Thursday’s decision.
Policy forecasts
Although Thursday’s decision was fully expected, the market will inevitably reflect on the fact that the ECB is cutting key interest rates to a periodic economic improvement, despite upward revisions to its inflation forecasts.
Taking a step back, we find that inflation fell significantly last year and inflation expectations stabilized, which justifies the decision to reduce policy restrictions.
However, upward revisions to the ECB’s inflation forecasts, as well as recent upward surprises for wage growth and economic activity, underscore the need for a cautious approach to future policy decisions.
Unsurprisingly, Lagarde has been keen to avoid precommitting future policy path, providing little clarity on the number of cuts or the pace of easing to proceed.
With the ECB also needing to consider the Fed’s slower start to its interest rate cutting cycle and the associated downward pressure it is putting on the euro, the future pace of interest rate cuts is likely to be measured and gradual. We expect the ECB to cut interest rates in September and December, although a rate cut in July is not on the table now.
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Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
