Where are interest rates going? The European Central Bank (ECB) will provide some answers to this question when it delivers its rate decision on Thursday. The question hanging over the meeting is whether policymakers fully abandon the gradual approach to easing suggested in September, or whether they stick to the script laid out at the last meeting. Inflation has come down and risks appear more tilted towards the downside in terms of prices and growth. A 25bps cut that acknowledges the downside risks to growth and recent disinflationary trend, absent too much by way of forward guidance, with the ECB sticking to its meeting-by-meeting mantra, seems the most likely outcome. And while a cut this week does not preclude a gradual approach, markets may see otherwise. 

Inflation slowing 

The ECB is generally expected to cut rates by 25bps following a slowdown in inflation and wage growth. The annual inflation rate in the Eurozone was 1.8% in September 2024, down from 2.2% in August. The flash PMI for September also shows average prices charged for goods and services in the Eurozone rising at the slowest rate since February 2021. 

On Friday, September 27th, data showed France’s combined goods & services CPI was the weakest on record for a September. And we have seen the softest Sep MoM goods inflation since ’09. It was also the weakest Sep MoM services inflation on record. Overall, prices fell by 1.1% in September from the prior month, according to the revised figures, though we can point to the Olympics as a potential cause. Nevertheless, it just adds to the rather gloomy picture emerging in Europe.  

Dovish noises 

Policymakers have sounded on the dovish side ahead of the meeting. French central bank chief Francois Villeroy de Galhau said a cut is “very likely” and such a step “won’t be the last”.  Bundesbank Chief Joachim Nagel, one of the most hawkish members of the Governing Council, said he’s willing to talk about an interest-rate cut. ECB President Christine Lagarde has made it pretty plain that a cut is the most likely outcome amid weakening economic growth and a sharp fall in inflationary pressures. She said latest developments had strengthened the central bank’s “confidence that inflation will return to target in a timely manner,” and said this would be taken into account in October.  This was seen as a pivot away from the ‘gradualist’ approach she was evincing at the September 12th meeting. Chief economist Philip Lane has said the ECB would need to step up rate cuts in the outlook worsens. 

Assuming a cut is coming, the market will be most concerned about the guidance for future cuts and whether the ECB gives a signal that it feels it needs to catch up a bit. But we should not assume a cut is a given – in September the ECB was pretty confident that a gradual pace of easing was fine. It lowered growth forecasts and stuck to this line – has all that much changed since then? Certainly, inflation has come down a lot, but services inflation remains around 4%. Given that the Governing Council seemed to be taking a more gradualist approach in September, a cut this week would signal a willingness to favour growth over any lingering inflation concerns.  It could also signal the ECB feels it got too far behind the curve by playing it cautious. 

Hawkish surprises? 

Remember the ECB staff projections in September have already factored in lower growth, whilst the recent move lower in the rate of inflation suggests it will undershoot the forecasts, with staff projections having anticipated a slight uptick in the tail end of the year. So, whilst they are very likely to cut, they could have a hawkish surprise in store in terms of the guidance – markets are already well priced for easing, with the euro sinking to a two-month low ahead of the meeting. The ECB can’t stay too far behind the curve for too long, but anything remotely leaning to September’s gradualist approach could produce some hawkish repricing in the front end and strengthen the euro, even if this does not last for long. And we could yet seem the ECB hold fire – dovish hold or hawkish cut seem to be the two most likely scenarios. They are not ready to throw the towel in yet, though markets may well see a cut this week as the ECB tacitly, if not openly, admitting they are ditching the more gradual approach. 

Yet, the divergence in the economic performance of the US and Eurozone suggests further euro weakness could materialize as markets reprice expectations for the Fed’s and ECB’s respective terminal rates. In that sense a cut today or holding fire is less important than it may appear at first. A trade war, should one occur in the event of Donald Trump winning the presidency, would be another euro-negative factor to consider amongst the monetary policy details.  

Markets are pricing in 2 more 25bps cuts this year and a further 100bps next year. Ultimately, for the euro the pace and timing will matter less than the ultimate destination. 

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