What is Required for the ECB to Cut Rates Quickly?

The European Central Bank (ECB) has maintained an interest rate of 4% since September 2023, as noted by analysts at Deutsche Bank Research.

According to their analysis, the ECB began its easing cycle in June with a 25 basis point cut. The current forecast anticipates further rate reductions in 2024, with two more 25 basis point cuts projected for September and December, leading to an eventual rate of between 2.00% and 2.50% by late 2025 or early 2026.

To implement quicker and more substantial cuts, several critical conditions must be navigated by the ECB.

First, the bank’s ability to lower rates is largely dependent on its assessment of medium-term inflation risks. There are concerns about inflation potentially failing to meet the 2% target in the medium term, influenced by factors such as the risk of a hard economic landing and the stability of inflation expectations.

While Deutsche Bank’s analysts observe that the likelihood of a hard landing has increased, it is not considered inevitable. Factors such as weakened labor market conditions and possible fiscal tightening could exacerbate these risks. Presently, there is some indication of a softening labor market, evidenced by a composite employment PMI dipping below 50; however, this has yet to lead to significant job losses or reduced wage pressures. The ECB will be looking for clearer signs that labor market weaknesses are impacting wage growth.

Additionally, expectations regarding fiscal policy, including the potential lifting of energy support measures and the reinstatement of fiscal rules, could stifle economic recovery and influence ECB decisions.

Another essential factor is the ECB’s stance on whether inflation is transitory or persistent. The bank had previously raised rates quickly in response to unexpected inflation, so a rapid reversal would necessitate a belief that current inflation is transitory. Given that inflation remains above target and there are no immediate signs of a sharp decline in inflation metrics, it is unlikely that the ECB will decrease rates as quickly as they were increased.

Analysts from Deutsche Bank indicate that while current inflation expectations have decreased slightly, they still remain above levels that would typically encourage significant easing. Without a notable decline in these expectations, the ECB may be reluctant to expedite rate cuts.

The concept of the neutral rate is also pivotal in shaping the ECB’s policy choices. When the ECB first raised rates in 2022, it aimed to return to a neutral level of approximately 1.50% to 2.00%. With current rates at 3.75%, a reduction to a neutral level would require further cuts. Analysts suggest that if the ECB identifies the neutral rate as being between 2.00% and 2.50%, it could support more rapid reductions, especially if inflation risks diminish.

The bank’s prior experience with swift rate increases when rates were far from neutral suggests a willingness to reduce rates quickly if needed. Furthermore, the existing policy stance might be seen as counterproductively restrictive, potentially prompting faster cuts if financial conditions were to tighten significantly or if credit conditions worsened.

However, recent data show that financial conditions are not tightening to a degree that necessitates immediate action. Analysts at Deutsche Bank point out that, despite an increase in real interest rates, there is no clear indication that the current policy stance is excessively restrictive.

While the market currently anticipates modest rate cuts in September and December, Deutsche Bank believes there is room for a more aggressive approach should downside risks become more evident. The ECB will continue to monitor evolving data and broader economic conditions, and any shift toward weaker inflation and growth could lead to quicker rate reductions.