Inflation: why the European Central Bank will continue to walk on eggshells

Because if a consensus emerges that the ECB will lower its key rates by 0.25% this Thursday, caution should remain in order for the second half of this year. Here’s why.

1. Why this measure is so awaited

In all probability, the ECB should therefore announce a 0.25% rate cut on Thursday. The rate of the deposit facility – i.e. the rate at which commercial banks are remunerated for depositing their excess liquidity with their respective national banks (Editor’s note: the BNB, with regard to Belgium) – should thus increase from 4% to 3 .75%. This will clearly mark the end of a cycle. Since June 2022, the ECB has in fact made no less than ten rate increases, going from -0.5% to 4%, a difference of 4.5%. And since last October, the European monetary institution has maintained its rates at a record level.

With this upward cycle, the ECB intended to combat the inflationary spiral of the last two years, resulting in particular from the energy crisis, geopolitical tensions and even disruptions in international trade. “It would be a very big surprise if the ECB did not decide to cut rates this Thursday and this could then cause a correction in the markets”, explains Eric Dor, director of economic studies at the IESEG School of Management. And to continue: “But the opinion on the financial markets is 96% that this rate cut will take place. This is evident from the analysis of how derivatives predict the future direction of rates. And all the tenors of the ECB and the most prominent governors, even those who are part of the clan of “hardliners” in the fight against inflation like Pierre Wunsch for example, have suggested that such a reduction was going to take place”.

2. Why caution will prevail in the months to come

If the announcement of the rate cut is therefore expected, it is above all the comments which will accompany it which will attract attention. Comments which will certainly be marked with caution. Because the recent indicators are clear: if we are now very far from record inflation – which peaked in October 2022 on an annual basis at 10.6% against a backdrop of soaring energy prices and the Russian offensive in Ukraine – it nevertheless still remains tenacious. Thus, according to the latest figures from Eurostat, in May, annual inflation in the euro zone stood, on an annual basis, still at 2.6%. A slight rebound compared to the April figure, where the increase was 2.4%. A small difference but which had the effect of a bit of a cold shower for some observers, who see it as confirmation that this fight against inflation has not yet been won. As a reminder, the ECB’s mandate provides that the institution’s monetary policy is conducted in order to adhere to an inflation objective of maximum 2%. So we are still beyond that.

Here, what raises some concerns is the slight rebound in wage growth: the annual growth rate of average negotiated wages in the euro zone was 4.69% in the first quarter of this year, compared to 4. 45% in the last quarter of 2023. An increase in wages which, if not brought under control quickly, could revive inflationary pressures, in particular through its effect on the prices of goods and services (Editor’s note: the prices of the latter have increased by 4% on an annual basis) charged by companies to consumers. Companies that might prefer to raise prices rather than cut into their profit margins. “But the ECB’s chief economist explained that these latest figures did not call into question the fundamental downward trend in inflation. However, this persistence of the rise in wages will be likely to make the ECB very cautious going forward. And we must not believe that after ten successive rate increases, we will now witness a succession of reductions mechanically”, adds Eric Dor. In addition to the 0.5% drop which should take place this Thursday, the latter is counting on two other additional cuts of around 0.5% each before the end of this year, in September and December. Which would therefore bring the ECB’s main rate to 3.25% at the end of the year. To be confirmed because other observers are instead counting on two reductions and a rate of 3.50% at the end of 2024.

But what will the European Central Bank decide this Thursday? The answer depends on inflation in Europe but also on what is happening in the United States…

Caution also justified by the fragility of a geopolitical context that is still very unstable. “This geopolitical context contributes to increasing risks. We are not immune to a new surge in energy prices, for example through rationing of the supply of oil and gas by the Gulf countries, in solidarity with the populations in Gaza. Or further disruptions to global trade following terrorist acts, as we saw with the Houthis. This geopolitical context remains a factor which makes forecasts very uncertain”explains Eric Dor again.

More fundamentally, Eric Dor explains that we will not return, for a long time, to the negative rates which were in force in 2022. An “abnormality” then justified on the part of the ECB by the desire to revive the European economic machine, which is seized up. by the consequences of the Covid crisis. “It is likely that we will converge towards neutral rates, neither too restrictive to combat inflation nor too accommodating to counter the risk of deflation., he said, estimating, ultimately, this range of “neutral” rates between 2 and 2.5%. And to point out some structural changes in the global economy: the return to certain forms of protectionism, the trend towards more conflictual global trade, the costs linked to the energy transition and industrial relocation efforts…

3. A rate cut, what next?

Will the start of this cycle of lower rates quickly benefit players in the “real” economy, consumers and businesses through better credit conditions, particularly on the front of mortgage loans for individuals? The answer here must be nuanced. “The reduction in rates on deposit facilities will lead to a reduction in rates on the money market and therefore in the rates at which banks lend to businesses. There will therefore be a slight easing of credit conditions on the markets but we should not expect miracles either. As long as Christine Lagarde does not say that we are heading for a succession of rate cuts, this relaxation will remain modest because everything will depend on the anticipation that the financial markets will have on the future of events., explains Eric Dor again. And as far as the stock markets are concerned, the fall in rates has already been incorporated into stock prices.

ECB official does not expect interest rate cut in July

In recent years, commercial banks have been the big winners from high rates: they currently benefit from 4% interest on their excess liquidity (Editor’s note: those which exceed the required reserves, representing 1% of their deposits) deposited with national banks. The BNB thus paid a nice jackpot annually, of almost 8 billion euros per year, to Belgian banks, in remuneration for this excess capital. At European level, interest revenue reached the astronomical sum of 124 billion euros. A good yield… For these banks, the drop in rates will therefore also have an impact, even if this Thursday they will still benefit from a fairly comfortable yield of 3.75%…

When the ECB precedes the Fed

This is an unprecedented situation, by probably lowering its rates by 0.25% this Thursday, the European Central Bank should draw more quickly than its American colleague, the American Federal Reserve (Fed). “In general, the ECB follows the Fed with a certain delay in terms of rate developments. In the present case, the ECB would therefore be ahead of the Fed. The rate differential here would be in favor of the dollar. Large investment funds could therefore give priority to the dollar over the euro, which would make goods purchased in dollars, such as oil or certain raw materials, more expensive in Europe., explains Eric Dor. And to conclude: “This factor could be likely to revive inflation but the chief economist of the ECB recently said that we should not exaggerate the extent of this negative effect”.