ECB is gearing up for rate cuts, officials say

The European Central Bank (ECB) is on the verge of cutting interest rates for the first time since Covid, signaling that policymakers are finally convinced that inflation no longer poses a serious threat to the economy.

According to at least three ECB officials—Philip Lane, Gediminas Simkus, and Boris Vujcic—eurozone inflation should return to the central bank’s 2% target by the middle of 2025. In the meantime, there’s enough progress to begin cutting rates as soon as next month.

“My thinking is that there are some other interest rate cuts coming in the future, but I will restrict myself from elaborating on how many, even if I have already expressed that this year, I would expect three cuts,” said Simkus, who also serves as Lithuania’s central bank governor.

The latest eurozone economic data “improve my confidence that inflation should return to target in a timely manner,” Lane, the ECB’s chief economist, told a Spanish newspaper.

Vujcic, who also governs the Croatian National Bank, agrees that the “incoming data so far are consistent with our projections.”

There’s a reason why ECB officials are confident. For starters, the eurozone’s inflation rate has been cut in half since last year, with the Consumer Price Index falling from an annual rate of 5.5% in April 2023 to 2.4% this past April.

Meanwhile, the eurozone economy entered into a recession last year before posting a modest 0.5% year-over-year rise in the first quarter of 2024.

These indicators suggest that the ECB has been successful in cooling the economy. But experts warn that doesn’t mean rate cuts will be fast and furious.

Cautious cuts?

The ECB’s vote of confidence has convinced investors that rate cuts are on the immediate horizon. According to the Financial Times, investors expect the ECB to lower rates by an average of roughly 0.7 percentage points this year, beginning in June.

While economists agree that a June rate cut is likely, some believe the ECB will wait before lowering rates again in the second half of the year. Moving too quickly risks reigniting inflation and undermining the ECB’s credibility.

“Beyond June, the uncertainty and the risks to the inflation outlook argue for caution, and [ECB chief Christine] Lagarde may hold back with signals,” said Ulrich Kater, chief economist at DekaBank.

“[S]ince the cost of being caught out by a resurgence of inflation would be high (a U-turn would seriously undermine credibility), it’s understandable that the Governing Council is being cautious,” said Bloomberg chief European economist Jamie Rush.

Even members of the ECB’s top brass are warning their colleagues not to jump the gun on successive rate cuts.

“Assuming there are no surprises between now and [June], as you say in French, it’s a ‘fait accompli,'” ECB Vice President Luis de Guindos told French newspaper Le Monde. “As for what happens afterwards, I’m inclined to be very cautious.”

There’s a very good reason why de Guindos wants to exercise caution, and it has something to do with what’s happening on the other side of the Atlantic.

The Fed effect

Although the ECB is expected to beat the Fed to the punch in cutting interest rates, how far it’s prepared to go could depend heavily on the U.S. central bank.

“What the Federal Reserve decides is crucial not only for the United States but also for the global economy, which also affects the euro area,” de Guindos admitted in his interview with Le Monde.

That means the ECB’s interest rate decisions won’t be made in a vacuum.

If the ECB cuts interest rates aggressively while the Fed stands pat, it risks widening the interest rate gap between the two central banks. A much lower ECB rate could weaken the euro and put upward pressure on inflation. And nobody wants that.

The ECB’s current benchmark rate is 4%, compared to the Fed’s target of 5.5%.

Since doubling down on plans to cut interest rates in March, the Fed has walked back expectations following a string of hotter-than-expected inflation reports. Economists still believe the Fed prefers to cut rates but won’t act too soon because it fears reigniting inflation.

“They do have some room to cut, but they don’t want to get it wrong. They do not want to be the Fed that cut rates as inflation kept beating expectations. So they want to see more data toward the right direction and they are willing to wait,” said George Lagarias, chief economist at Mazars.