The European Central Bank cut rates, as expected, and was rather vague about the next steps, also as expected. Rather than being rushed into action by some crisis, the quarter-point cut from 4% to 3.75% looks precautionary. It could indicate a change in the way the ECB is making policy. And it shows how the risks are evolving.  

We have been on inflation watch all year ready for the second round, but it’s been the dog that didn’t bark. Certainly, inflation remains frothy and disinflation is lumpy – just look at three-month annualized services inflation running at 5.2%, and the one-month rate at 6.5%. May headline CPI was up from +2.4% to +2.6% and core CPI rose from +2.7% to +2.9%. But it’s not exploded higher, more just looking like the last mile is going to be bumpy. If it hadn’t been for the strong signals given by policymakers that they would cut interest rates in June, there is ample evidence in the macro data that would warrant standing pat for now. But the ECB is looking ahead and seems to be forward-looking once more. It’s not about the data that’s just gone but the projections. President Lagarde stressed the ECB’s “confidence in the path ahead” has been increasing in the past months. This is an important shift; one that signals a move from firefighting to fire prevention. 

The seemingly interesting bit was the ECB chose to raise rates despite not only the uptick in the recent inflation data, but also with staff forecasts showing higher inflation. Inflation forecasts were raised to 2.5% from 2.3% this year, 2.2% from 2.0% in 2025. We are moving from the point of tacit acceptance of higher inflation to explicit. It’s also true that the rate of inflation has come down a lot – whether it’s 2.5% or 2.3% is marginal stuff compared to 10% like we saw before. And wages are not rising as fast as feared: they maybe are a bit elevated but forward-looking indicators signal that wage growth will moderate during the year. Moreover, cutting to 3.75% still leaves rates restrictive – indeed because of the decline in inflation policy rates are more restrictive now than they have been. The ECB is mindful of inertia and staying too tight for too long. The risk, of course, is that you end up letting inflation loose again. Former president Trichet was remembered for hiking too early; Lagarde does not want to be remembered for being too quick to cut. 

The ECB did not give much away in terms of the likely future path of monetary policy, it’s wedded firmly to ‘data-dependence’, but it looks as though we could see another two rate cuts this year if the logic of this week’s meeting holds along with the expected course of the data. The market thinks maybe just one. It’s not quite one-and-done, more like one-and-wait-and-see. President Lagarde said there is a “strong likelihood” ECB has kicked off an easing cycle but could not be drawn on committing to further cuts. She said: “I cannot confirm that it is the dialling [back] process that is underway. There is a strong likelihood, but it will be data-dependent.” 

The funny thing is that the ECB doesn’t tend to move before the Fed, and it doesn’t tend to start cutting before a recession. The Fed looks increasingly likely to follow in September. Eurozone growth has been lacklustre but is starting to improve. Maybe the ECB is, actually, ahead of the curve?  

Neil Wilson

Chief Market Analyst at Finalto

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