June 2024
Azad Zangana, Senior European Economist & Strategist
While back-to-back cuts are unlikely, there is plenty of room for the European Central Bank to surprise cautious investors, according to Azad Zangana, Senior European Economist & Strategist at Schroders.
The European Central Bank (ECB) has announced that its three main policy interest rates will be lowered by 25 basis points – the first cut in rates in almost five years. The move was unanimously expected by economists and almost fully priced by financial markets following strong hints of imminent easing by members of the Governing Council.
Attention now turns to the future pace of easing which remains uncertain. An above-consensus rise in May’s Harmonised Index of Consumer Prices (HICP) inflation rate to 2.6% year-on-year had raised questions as to whether the ECB would cut at all. The unexpected print also clearly influenced the press conference communication following the decision.
ECB staff projections for the headline annual inflation rate were raised for this year from 2.3% to 2.5%, and from 2% to 2.2% for 2025. However, the projections for 2026 remained unchanged at 1.9%, suggesting ongoing confidence that policy will return inflation to target. Indeed, during the press conference, ECB president Christine Lagarde explained that staff expect inflation to fluctuate above target for the rest of this year and into next year, before returning to the 2% target in the second half of 2025.
Lagarde stated that while interest rates have been lowered, they remain restrictive, and will need to fall much further before they are considered to be neutral. This suggests that interest rates are likely to be lowered further over the rest of this year, even if inflation remains somewhat elevated.
Lagarde also explained that the main cause for the persistence in inflation was a catch-up effect of wages to past price increases. This catch-up is now causing services companies to increase their prices. We can see this in the higher rates of services inflation compared to goods and the headline measure (see chart 1, below). Lagarde also mentioned that early indicators suggest wage growth is now stabilising. Meanwhile, data showing that companies are not passing on the full cost of wage increases (at the detriment of profits), suggests that inflation is likely to moderate.
If the ECB is confident that the economy is on the right track, how fast can interest rates fall?
Polling conducted by Reuters before the decision shows that the consensus amongst economists is for the ECB to cut rates twice more (quarter-point cuts) by the end of this year, and three times in 2025. However, investors appear to be more cautious. Pricing based on forwards of overnight index swaps (OIS) show that less than one more cut is priced for the second half of this year, and only two cuts for next year (see chart 2, below).
By contrast, Schroders’ forecast is more optimistic, with three more cuts forecast this year, and two the next. This suggests some upside for both European fixed income markets (lower yields mean higher prices) and equity markets, which would be supported by higher economic growth, and lower discount rates.
