Will the ECB cut interest rates?

Last Updated on Thursday, 6 June, 2024 at 9:30 am by Andre Camilleri

All signals reported in the international financial press seem to indicate that the European Central Bank will cut interest rates from their historic highs, on the same day this article is being published. This will mean that the ECB is likely to be one of the first major central banks to cut rates. The market has been betting heavily that the ECB will lower its benchmark deposit rate by a quarter percentage point from its record high of 4% after eurozone inflation fell close to the bank’s 2% target in recent months. Eurozone inflation has fallen from above 10% at its peak in 2022 to a near three-year low of 2.4% in April. However, the May figures, published last week, indicate an upturn in eurozone inflation, which accelerated for the first time this year from 2.4% in April to 2.6% in May.

Does this imply that despite the signals given in recent days, the ECB might now hesitate to cut rates? It does not seem like it. Although, the European Central Bank had pledged to take a data-dependent approach to monetary policy, the sensation is that it will brush off the recent upturn in eurozone inflation and start cutting rates anyway.

Looking globally, the central banks of Switzerland, Sweden, the Czech Republic and Hungary have lowered borrowing costs this year in response to declining inflation. In contrast, however, the US Federal Reserve and the Bank of England are not expected to cut rates before the summer, while the Bank of Japan is more likely to continue raising them. Some analysts have warned that if the ECB diverges from the Fed by cutting rates more aggressively it could cause the euro to depreciate and push up inflation by raising the price of imports into the bloc. Some analysts argue risks are skewed towards less cuts, mainly on the back of sticky services inflation and a resilient labour market. They believe the ECB’s likely action could be a mistake if eurozone inflation continues to deviate from its 2% target, especially as the US Federal Reserve and the Bank of England delay their rate cuts.

All types of analysis indicate that inflation had fallen faster in the eurozone than the US, because the region had been hit harder by the energy shock triggered by Russia’s invasion of Ukraine. However, beyond whether the ECB cuts interest rates, such interest rates will remain in restrictive territory this year to ensure that inflation keeps easing. That is what theory suggests.

Reality on the ground is that data is showing that eurozone wage growth picked up to a near-record pace at the start of this year, but is now showing some signs of deceleration, although still on the increase. 

Personally, my view is that with the record climb of interest rates, this did pretty nothing to dent one of the main factors effecting eurozone inflation, that is, service inflation. As we all know, service inflation does not respond to monetary policy as quickly as other types of inflation. Add to that the fact that I personally believe we have a choice to make to really understand the new reality of eurozone economies and their composition.

On one hand, maybe it is time to revisit whether the holy grail of the 2% inflation target is something still feasible considering that most eurozone economies have a heavy composition of services, and the underlying reasons of services inflation is linked to long-term issues related to demography, skills and investments in technology. This brings me to the second linked point. One of the ways to ease pressures on wage growth, is by investing in technology to increase efficiencies and possibly automate certain processes, enabling businesses to do more with less people. However, when interest rates are high they are also deterring such much-needed investments in technology. Which means that it is likely that the tightened monetary policy “medicine” to bring down inflation, is having a reverse effect within the background of having many eurozone economies being heavily service-based.

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