European Central Bank Cuts Rates to 3.75% as Inflation Remains Stubbornly High

Services

Equity Investment with CA Abhay

Stock Market Masterclass

Option Trading with CA Abhay

FNO Stocks with CA Abhay

Equity Trading with CA Abhay

ECB Cuts Rates Amid Ongoing Battle with Persistent Inflation

Team FS

06/Jun/2024

Key Points

The ECB cut its deposit rate to 3.75%, marking the first reduction since 2019, as inflation remains above the 2% target.
Inflation forecasts for the euro zone have been raised, signaling that high borrowing costs will continue to combat persistent price pressures.
Further ECB rate cuts are uncertain and will depend on inflation data and economic activity, with a cautious outlook influenced by the U.S. Federal Reserve's actions.

The European Central Bank (ECB) has taken a significant step by cutting its deposit rate to 3.75% from a record high of 4.0%. This move, announced on Thursday, reflects the ECB's acknowledgment of progress in its fight against high inflation while also signaling that the battle is far from over. The decision comes amidst a backdrop of inflation in the 20 euro-sharing countries falling from over 10% in late 2022 to just above the ECB's 2% target in recent months, primarily due to lower fuel costs and the normalization of supply chains post-pandemic.

Inflation Progress Stalls, Future Cuts Uncertain

However, the progress in reducing inflation has recently stalled. This stagnation has introduced uncertainty into what appeared to be the start of a significant easing cycle by the ECB only a few weeks ago. Like the United States, the euro zone is experiencing signs that inflation may remain persistent, complicating the ECB's path forward.

ECB Raises Inflation Forecasts, Stresses Caution

In announcing the rate cut, the ECB also raised its inflation forecasts for the current and next year. ECB President Christine Lagarde emphasized that any future rate reductions would depend on incoming economic data, reaffirming the necessity of maintaining borrowing costs at levels that effectively curb price growth. Despite the recent decline in price growth, domestic price pressures remain robust, fueled by elevated wage growth. As a result, inflation is projected to stay above the ECB's target well into the next year.

Market Reaction and Investor Expectations

The financial markets reacted to the ECB's announcement by adjusting their expectations for future rate cuts. Investors now anticipate only one more rate cut this year, with a slight possibility of a second. This cautious outlook is driven by recent stronger-than-expected data on euro zone inflation, wages, and economic activity, which have raised concerns about the ECB's ability to achieve its inflation targets smoothly.

Christine Lagarde's Press Conference to Provide Further Clarity

ECB President Christine Lagarde's upcoming press conference is expected to shed light on the pace of future rate cuts and whether a reduction in July remains a possibility. The ECB's decision aligns it with the central banks of Canada, Sweden, and Switzerland, all of which have recently reversed some of their steep interest rate hikes. The U.S. Federal Reserve is also anticipated to join this trend, though it has been held back by stronger-than-expected inflation readings earlier in the year.

The "Last Mile" Challenge in Reducing Inflation

The ECB faces a challenging "last mile" in achieving its inflation goals, a concern echoed by influential board member Isabel Schnabel. The recent rebound in services inflation, which reflects domestic demand, has been particularly worrisome. Inflation in services rose to 4.1% in May from 3.7% in April, highlighting the ongoing inflationary pressures within the euro zone economy.

Economic Growth Reduces Urgency for Rate Cuts

Most economists predict that the ECB will continue to cut its policy rate over the coming months, potentially bringing it down to 2.50% by the end of 2025. However, they also foresee just two more rate cuts this year, likely in September and December. HSBC economist Fabio Balboni noted that while further cuts remain the central case, sustained resilience in services inflation could force the ECB to adopt a more cautious approach.

A rebound in economic growth has also reduced the urgency for rate cuts, as high interest rates do not appear to be significantly choking economic activity. The real test for the ECB may come from the U.S. Federal Reserve. A more restrictive Fed could lead to a weaker euro and higher imported inflation for the euro zone, complicating the ECB's efforts to manage inflation and economic growth simultaneously.

Interplay with the U.S. Federal Reserve's Policies

Economist Mohit Kumar from Jefferies highlighted that the pace of ECB rate cuts would depend significantly on the Fed's actions. If the Fed does not cut rates this year, it could limit the ECB to just two cuts in 2024. The intertwined dynamics between the ECB and the Fed underscore the complexity of managing monetary policy in a globally interconnected economy.

Conclusion

In summary, the ECB's decision to cut rates to 3.75% marks a pivotal moment in its ongoing battle against inflation. While acknowledging progress, the ECB remains cautious, with future rate cuts hinging on economic data and the broader inflationary landscape. The interplay between domestic price pressures, economic growth, and external factors such as U.S. Federal Reserve policies will shape the ECB's path forward in navigating this challenging economic environment.

Also Read : Muthoot Microfin Partners with SBI for Strategic Co-Lending to Boost Rural Women's Entrepreneurship

Join our Telegram Channel and WhatsApp Channel for regular Updates.