The European Central Bank has resolved this Thursday without surprises in a transition meeting that finally opens the door to future movements. The Governing Council has decided to maintain euro zone interest rates at 4.5%, the highest level since 2001, as expected. But Christine Lagarde has been writing the script for a first rate cut in June, practically since the March meeting, for weeks, a possibility that is reinforced by this meeting. The ECB is emerging as the first monetary authority that will lower rates within developed economies, ahead of the United States Federal Reserve. The evident decline in inflation and weak growth put increasing pressure on the ECB to lower the price of money, a cut that some voices in the Governing Council already demanded this Thursday. Lagarde has preferred to wait a little longer and has announced that she does not commit in advance to a specific path of rates. Taking the step of cutting them before the US also poses new challenges, such as the inflationary risk of a predictably weaker euro.
The latest inflation data in the euro zone pave the way for the change of course in the ECB's monetary policy. The inflationary spiral that followed the economic collapse due to the pandemic, and the skyrocketing energy prices that caused the start of the Ukrainian war, caused a wave of rate hikes unprecedented in the history of the euro. The rise began in July 2022, from the zero level, and did not stop until reaching 4.5% last September.
It is now that inflation appears to be deflating convincingly for the ECB, approaching the 2% target in a way that the central bank must consider widespread and sustainable, not a flash in the pan, before finally deciding to lower rates. In March, prices in the euro zone grew by 2.4% year-on-year, one tenth less than in February. And the core inflation data also left an encouraging decline, from 3.1% in February to 2.9% the following month. “Inflation has continued to moderate, thanks to the drop in the prices of food and goods,” the entity noted.
Its statement added that if the three key variables that the central bank monitors to decide to lower rates—inflation prospects, underlying rate and transmission of its monetary policy—reinforce confidence that inflation is heading towards the objective in a sustained manner, “ "It would be appropriate to reduce the current level of monetary policy restriction." It is the new statement with which Lagarde points out that June would be the time to lower rates. According to Felix Feather, economist at abrdn, the ECB “has not surprised by maintaining interest rates for the fifth consecutive time. As expected, the institution laid the foundations for an imminent easing cycle by adjusting its monetary policy statement. “This decision confirms that, barring major economic surprises, the ECB is on track to apply a cut at its next meeting in June.”
But the central bank does not want to leave any loose ends and also warns that “domestic inflationary pressures are intense and keep inflation in service prices at high levels.” At the March meeting, Christine Lagarde already pointed out that in June there would be many more elements to decide on a rate cut than at this April meeting. The most relevant, the increase in salaries, which will be known on May 23 and which is a key indicator to see if inflation in the services sector has finally cooled as well. In the minutes of that meeting, the Governing Council already agreed that the decline in inflation could be “more uncertain, slow and bumpy” than expected and reality is in fact leaving new elements of concern. Lagarde has insisted that the decline in inflation will not be linear and will register fluctuations caused mainly by the price of energy. Given the uncertainties, the ECB reiterates that "the Governing Council will continue to apply a data-dependent approach and in which decisions are taken at each meeting, without committing in advance to a specific rate path."
The price of oil, which seemed like a concern already buried for the ECB, is rebounding and has gone from $75 a barrel in December to the current $90. Geopolitical tension and the dynamism of demand are contributing to the rise in its price. This is a factor that does not threaten the most likely scenario of a rate cut in June, but does threaten the subsequent path of cuts in the price of money. In fact, the big debate ahead for the ECB will be the pace at which to normalize its monetary policy in the coming months, with almost anemic growth in the euro zone.
Supporters of lowering rates now
The debate between hawks and doves in the ECB has revolved for months about how much growth to sacrifice in favor of controlling inflation and has exploded at this Thursday's meeting. It has not been a purely formal Government Council, since some members ("few", as Lagarde explained) have already shown themselves in favor of a first rate cut, confident enough in the evolution of inflation to lower them. But the representatives of northern Europe have already shown days ago their preference for pausing the cuts during the summer. This is what the governors of the Netherlands and Germany have stated.
Furthermore, financing conditions in the euro zone will inevitably be influenced by what the Federal Reserve decides, despite the fact that Lagarde has insisted that the ECB is independent in its decisions. “We are not dependent on the Fed. We do not speculate on what other central banks will do,” he assured. The reality is that the inflation data in the United States released this Wednesday has been a bucket of cold water on the cycle of rate cuts that households and companies expect. Prices in the US do not falter and the CPI for March stands at 3.5% year-on-year, still very far from the goal of 2%, which is beginning to freeze expectations of cuts by the Fed for this year . The market's chances of a cut in June have sunk to 17% after the data was published, and those of a cut in September are reduced to 44%, compared to 70% before the US CPI was released. Consequently, the market is also beginning to question the majority forecast until now of a total rate reduction path in the euro zone of 75 basis points in the euro zone.
Cutting rates before the Fed also poses a new challenge, even more so if the reduction in the United States is postponed in time. This gap in the monetary policy of the Fed and the ECB promises to strengthen the dollar and weaken the euro, which has already lost close to 3% this year and which these days is falling to November levels, at $1,073. The ECB forecasts growth for this year in the euro zone of only 0.6% and a weaker European currency implies a higher cost in purchasing energy, in dollars, and a new inflationary factor by making imports more expensive. “Lowering rates does not solve supply problems but it can make them worse. Subjecting the euro to weakness in this context (the rest of raw materials are also on the rise) implies more expensive imports. "Do we really want to stimulate consumption and the industrial sector to absorb imported inflation?" they ask Mapfre Economics. In short, an added difficulty for the ECB in the never easy task of creating consensus on what to do with interest rates.