The European Central Bank has cut interest rates for the first time in five years, with the eurozone’s key rate falling 25 basis points to 3.75 percent.
However, the bank also raised its projections for eurozone inflation over the next 18 months and warned it will keep interest rates on tight terms “for as long as necessary.”
The ECB is the second G7 country to press ahead with policy easing after the Royal Bank of Canada cut its key rate by 25 basis points (bps) to 4.75 per cent on Wednesday.
Economists and investors now expect the Bank of England to follow suit, with analysts divided over a summer base rate cut.
ECB President Christine Lagarde will be aware of the risks of straying too far from Fed policy
Markets had priced in the ECB’s first cut in some time, and the central bank had hinted at its policy direction in recent months as inflation eased and the bloc’s economy showed signs of stuttering.
The ECB said: “Given the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy tightening after nine months of keeping rates stable.”
But investors awaited comments from the ECB for guidance on the way forward and were met with a conservative outlook.
Despite progress on inflation, the ECB admitted that “domestic price pressures remain strong as wage growth remains high, and inflation is likely to remain above target well into next year”.
Eurosystem staff projections for headline and core inflation have been revised upwards for 2024 and 2025 compared to March forecasts.
The ECB now expects headline inflation to average 2.5 percent in 2024 and 2.2 percent in 2025, before falling below its 2 percent target to 1.9 percent in 2026.
The bank said: ‘The Governing Council is determined to ensure that inflation returns to its medium-term target of 2 per cent in a timely manner.
‘It will maintain sufficiently restrictive official rates for as long as necessary to achieve this objective.
‘The Governing Council will continue to apply a data-driven, meeting-by-meeting approach to determine the appropriate level and duration of restriction.
“In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, underlying inflation dynamics and the strength of monetary policy transmission.”
The ECB knows it must act cautiously after eurozone inflation rose from 2.4 to 2.6 percent in May, while core inflation also rose 20 basis points to 2.9 percent.
The bank will also seek to avoid decoupling monetary policy too much from that of the U.S. Federal Reserve, whose first rate cut is not expected until much later this year amid persistent inflation and surprisingly resilient economic performance in some areas. as your work sector. market.
The fear is that excessive decoupling from US policy would put further pressure on the euro, which could be reflationary and hurt growth. Similarly, the Bank of England will want to avoid similar problems with sterling in the coming months.
Simon French, chief economist at Panmure Gordon, said: “Central banks are aware that, with underlying inflation persistent in the United States, fueled in part by firmer demand conditions than those prevailing in the rest of the developed world, the The impact of the exchange rate on imported inflation through a deterioration in terms of trade in US dollars is an important risk factor.
‘It is notable that the Swedish krona, Swiss franc and Canadian dollar (where rate cuts have begun) have weakened more materially than the British pound and euro since the start of the year.
‘However, it should also be noted that both the krona and the franc have increased in dollar value compared to the day of the interest rate cut. This recovery will not go unnoticed in Frankfurt and London as they consider their own policy measures.’
Market prices suggest the ECB will cut rates twice more before the end of the year, taking its key rate to 3.25 percent.
When will the Bank of England cut?
Expectations about the timing of the Bank of England’s first interest rate cut have changed hugely this year, as new economic data has continued to alter market sentiment.
Not long ago, market prices suggested the Bank of England would join the ECB in a rate cut in June, but the UK central bank is now thought to cite still high underlying inflation and the looming general election. as reasons to wait until August.
UK consumer price index inflation rose more than expected, up 2.3 per cent in the 12 months to April, but down from 3.2 per cent the previous month, as core CPI proved frustratingly rigid by 3.9 percent.
But construction sector data released on Thursday could offer some optimism to the Monetary Policy Committee when it meets on June 20.
Thomas Pugh, economist at RSM UK, said: ‘The key news for the MPC was that the construction PMI input price index fell to 50.4, well below its five-year average of 66.2. .
‘The bottom line is that April’s difficult inflation numbers were probably a direct response to the increase in the minimum wage, rather than a reflection of underlying price pressures. Price pressures are now easing across the economy.
Market prices suggest the Bank of England could only achieve two rate cuts of 25 basis points each this year, taking the base rate from its current level of 5.25 percent to 4.75 percent.
UBS analysts, however, are more optimistic and expect cuts of 75 basis points by the Bank of England this year (taking the base rate to 4.5 percent by the end of 2024), followed by 175 basis points in 2025.
UBS said: “However, in light of the disappointing inflation data, we recognize the risk of a subsequent cut, in August.”
“Markets are currently pricing in 1bp of cuts for June, 9.5bp for August and the first rate is not discounted until November.”
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