European Central Bank to cut rates at last, but should we be careful of what we wish for?

Consensus among European Central Bank watchers is often hard to find – but Thursday’s (6 June) widely anticipated interest rate cut provides an exception. What will – and should – happen after that, however, is still a matter of contention.

The forecast ECB rate decrease – the first since 2019 – comes at a time of profound concern about the health of the European economy.

Weak productivity growth, slowing investment, skills shortages, and state-led industrial policies in the US and China have conspired to produce virtually stagnant growth and declining industrial output across much of the bloc.

Perhaps even more important than any of these factors, however, has been the effect of – and the ECB’s response to – the energy crisis triggered by Russia’s invasion of Ukraine in February 2022.

The subsequent surge in prices led the ECB to embark on the most aggressive series of rate hikes in its history, bringing its key rate from negative levels to a record high of 4% between July 2022 and September 2023. The bank has held rates steady ever since.

Inflation has since declined considerably, with the headline rate coming in at 2.6% last month: just decimal points above the bank’s 2% target rate, and well below the 10.6% peak reached in October 2022.

The decline, coupled with the ailing macroeconomic backdrop, has led many analysts to become increasingly vocal about the need to cut rates to boost investment and, ultimately, growth.

Maria Demertzis, a senior fellow at EU policy think tank Bruegel, told Euractiv that Thursday’s rate cut is probably several months overdue – but that this delay was itself entirely predictable.

Policymakers at the ECB tread carefully before any policy decision “because they move markets,” she said. “They need to be absolutely sure, and then a little bit more, before they change policy.”

Demertzis noted that this caution explains the ECB’s desire to delay a rate cut until it had collected further wage data over the first quarter of this year, even though wage growth had already slowed in the final three months of 2023.

“They prefer to take the cost of that second data point, the cost of waiting, rather than taking the risk of having gone wrong, and that one data point being a blip,” she said.

A rate cut the ECB will regret?

However, Carsten Brzeski, global head of macro research at ING, expressed concern about the potential dangers of cutting too soon. “Although no one has a crystal ball”, he told Euractiv, June’s rate cut “could become a cut [the ECB] will regret”.

Brzeski sketched out a potential scenario whereby Thursday’s rate cut is followed by a steep rise in GDP and wage growth and a surge in selling price expectations.

This, he said, could potentially trigger “a wage-price spiral”, whereby higher wages cause producers to pass on higher prices, which in turn leads employees to demand further salary hikes.

Risk of tricky EU-US divergence

Analysts were similarly conflicted about the danger of the ECB’s policy “diverging” from that of the US Federal Reserve – warning in particular that the decision to cut rates before the Fed could lead to the euro depreciating against the dollar, thereby driving up the cost of imports and, ultimately, prices in general – even if it may help exports.

However, Sander Tordoir, chief economist at the Centre for European Reform (CER), suggested that this worry is less serious.

He noted that the size of the eurozone economy, coupled with the small size of the expected 0.25 percent point rate cut on Thursday, means that it is unlikely that the “eurozone would import loads of inflation from the US”.

“I think there’s some concern, but I don’t think there’s real panic about this,” he told Euractiv.

Brzeski, however, suggested that it is not the impact on the exchange rate per se that is worrying ECB officials, but rather the fact that US inflation has tended to “lead” eurozone inflation by three to six months in recent years.

“If US inflation is really leading eurozone inflation and if US inflation is coming back, this would then stop or prevent the Fed from cutting rates – but this reflation story in the US could also become a story very quickly in the eurozone,” he said.

July meeting ‘a live decision’

Expectations also varied on how many rate cuts will occur this year, with most anticipating one or two more beyond June.

Such caution reflects current market expectations, with a reduction of fewer than 60 basis points predicted in 2024 – equating to two 25 basis point cuts plus a non-negligible possibility of a third.

“I must say I’m torn between either two additional rate cuts – September and December is still our base case – but I think there is a clear risk that it’s going to be less than that,” Brzeski said.

Tordoir was similarly cautious. “I think they will really assess at every meeting the latest set of data that comes in. And so I think [the ECB’s next meeting in] July is a live meeting. It could go either way.”

Towards a higher tolerance for uncertainty?

Analysts also disagreed about whether the ECB should adjust its policy framework moving forward, with some expressing concern that the bank’s desire to drive down inflation to 2% could end up inflicting unnecessary damage on the European economy.

Demertzis, in particular, argued that growing price volatility – itself largely a consequence of increasing geopolitical uncertainty – means the ECB should allow for greater “tolerance” for inflationary discrepancies away from its 2% target.

“The ECB talks a lot about uncertainty, but you have to realise that the greater the level of uncertainty, the greater the tolerance bands ought to be,” she said.

Brzeski, conversely, warned that such tolerance could generate greater market uncertainty about future ECB decisions, thereby risking further harm to the European economy.

This would actually make the ECB’s decision-making “even more erratic and even more discretionary,” he said.

[Edited by Anna Brunetti/Zoran Radosavljevic]