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The European Central Bank (ECB) decided yesterday to suspend the three key interest rates Cannot be adjusted. Last month, the ECB cut interest rates by 0.25 percentage points for the first time since September 2019. The deposit rate now remains at 3.75 percent. This cautious approach to reversing the series of rate hikes, which they have implemented since July 2022 to curb inflation, is exactly what the market had expected.
Why is the ECB opting for this, what are the expectations for the future, and what choices are other central banks making?
ECB interest rate developments (source: Holger Zschaepitz)
The Main objective of the ECB is to maintain price stability within the euro area, thereby contributing to economic growth and employment. Lower interest rates have a stimulating effect on economic growth, but can also (indirectly) lead to higher inflation. For an interest rate decision, therefore, the balance between stimulating the economy and controlling inflation is carefully sought. So, to understand the ECB's decision, we need to look at the economic and inflation data.
The figures show that the eurozone economy is growing in the second quarter, but probably at a slower pace than in the first quarter. The services sector is doing relatively well, while industrial production and goods exports are weak. Investment indicators point to subdued growth in 2024 amid heightened uncertainty. They expect the recovery to be further supported by consumption as there will be an increase in real income due to lower inflation and higher nominal wages. The labour market remains robust, with the eurozone unemployment rate remaining at 6.4 percent, the lowest level since the introduction of the euro.
Annual inflation in the eurozone fell from 2.6 percent in May to 2.5 percent in June. Both goods and services price inflation remained unchanged in June, at 0.7 percent and 4.1 percent respectively. They expect inflation to remain above the 2 percent target well into next year. This is partly because wages continue to rise at a high pace to compensate for the recent period of high inflation.
At 2.5 percent, inflation is still above the target of 2 percent. The ECB has therefore decided to keep interest rates relatively high in the hope of bringing down inflation. The ECB sees a weaker global economy or an escalation of trade tensions as important factors that could affect growth in the eurozone. Despite that, Christine Lagarde reiterated that interest rates will remain restrictive "for as long as necessary" to bring inflation back to the 2 percent target. She emphasized that the ECB is not tied to a predetermined interest rate, but that they make a decision based on the data at each meeting.
Nevertheless, it is expected that the ECB will decide to cut interest rates further in September. The bank itself is responsible for door for open. The market expected that there is about an 80 percent chance that interest rates will be cut in September, and once or twice in total this year. Klaas Knot, president of the Dutch Central Bank and member of the ECB's Governing Council, recently indicated that an interest rate cut in September is possible.
Other major central banks have also started cutting interest rates. The Swiss National Bank (SNB) was the first Western central bank to cut interest rates in March. In fact, they have already lowered interest rates to 1.25 percent a second time and may do so twice more this year. Swiss inflation is forecast to fall to around 1.3 percent, significantly lower than that in the Eurozone. The Appreciation of the franc has helped to contain inflation, but is now weighing on the competitiveness of Swiss companies. This plays a role in the SNB's decision to lower interest rates.
Also the Riksbank of Sweden has already lowered interest rates and expects to do so two or three more times this year. The Bank of Canada is expected to deliver a second rate cut on July 24. On the other hand, the Bank of England and the Reserve Bank of Australia are reluctant to ease due to persistent inflationary pressures. The Bank of Japan remains an exception, with a possible rate hike in July, driven by wage increases.
In the United States, the Federal Reserve is expected to cut interest rates in September due to better-than-expected inflation data. The probability of a rate cut in September is now more than 98 percent according to the market. Last week we wrote an extensive article about it and also explained the effect interest rate cuts have on the Gold price. Read it article here!
Photo: © Felix Schmitt for ECB
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