ECB ‘Terminal Rate’ Appears Excessive: Insights from Mike Dolan

By Mike Dolan

LONDON – Current market sentiment suggests that the European Central Bank (ECB) is unlikely to aggressively pursue rate cuts in the near future, a situation that could be either misguided or concerning.

Present projections indicate that the ECB’s interest rates will continue to exert a mild drag on the sluggish eurozone economy over the next two years, even as it gradually lowers its primary policy rate. Striking a balance between maintaining its inflation target of 2% and fostering positive growth without adopting a more stimulative monetary policy appears increasingly challenging, especially given the long-standing issues the region has faced.

The ECB has already taken preemptive measures ahead of the Federal Reserve and is expected to implement its second key interest rate cut before the Fed initiates its adjustments later this month. This approach seems logical given that the eurozone’s economic performance has lagged behind that of the U.S. over the past two years.

Moreover, Europe is particularly vulnerable to the ongoing economic struggles in China and the global manufacturing slowdown, as the manufacturing sector constitutes a significant part of its economy—about 20% in Germany and 15% across the eurozone. The rapid decline in core goods prices has led to disinflation, bringing the ECB’s inflation objectives into closer reach.

However, the real challenge lies not in understanding why easing measures are already being implemented but rather in anticipating their ultimate destination. Currently, money markets project that the ECB’s policy rates will stabilize at approximately 2.10%-2.20% over the next 12 to 18 months. If inflation indeed declines to the ECB’s 2% target by 2026, as anticipated, it indicates that "real" rates will remain positive throughout the economic cycle—above the neutral rate, which many ECB policymakers consider critical.

Additionally, market expectations suggest that ECB rates will lag more than 125 basis points behind those of the Fed. Interestingly, current pricing intimates that the Fed could ease its rates by 50 basis points more than the ECB throughout the cycle by the end of next year.

Market caution appears influenced by ECB officials, many of whom emphasize the need to rein in elevated service sector inflation and fast-rising wages. By underscoring their commitment to maintaining a somewhat restrictive policy, ECB officials may be trying to curb inflation expectations psychologically.

ECB board member Isabel Schnabel recently emphasized the importance of "perseverance" in policy and the central bank’s commitment to its targets to restore price stability after systemic shocks. She also noted that ambiguity surrounding the neutral rate complicates the process of determining the terminal rate.

The ECB’s reluctance to signal a return to more accommodative measures may stem from broader economic concerns. Unless significant structural changes have taken place since the pandemic, the ECB likely needs to enact substantial measures to reinvigorate the slow-growing region. For instance, the notable slowdown in global manufacturing, combined with continuing trade ties with a faltering Chinese economy, raises the prospect of falling growth and even deflation in the eurozone in the next year.

Economic analysis has revealed a sharp decline in annual core goods inflation in the eurozone, paired with notable deflation in Chinese factory goods prices. Some analysts warn that Western nations might significantly underperform inflation projections, potentially sliding into deflation as factors driving the recent inflation surge dissipate.

This situation raises critical questions regarding the likelihood of the ECB needing to adjust its monetary policy in light of these challenges. Prior to October 2023, "real" ECB policy rates had remained predominantly in negative territory for almost a decade. While geopolitical shifts and the loss of low-cost energy supplies from Russia have altered the landscape, many foundational issues affecting the region’s economic potential persist, particularly its aging demographic landscape, contrasting sharply with dynamics in the U.S.

The ECB’s cautious approach may also reflect its ability to enact robust stimulative policies. Surveys indicate a deterioration in bloc-wide employment even as wage and price growth remains elevated. This could force the ECB into a more hawkish position than warranted by eurozone growth trends.

In navigating these complexities, undershooting inflation expectations likely represents a more pressing concern for both the ECB and market participants.

The views expressed herein are those of the author, a columnist with established expertise.