Five Questions for the ECB – Reuters

By Yoruk Bahceli and Stefano Rebaudo

The European Central Bank (ECB) is expected to announce another rate cut on Thursday, but the future trajectory of its monetary policy remains uncertain. There is a divide among policymakers regarding whether the current weak growth outlook justifies concerns about inflation.

"This cut is relatively uncontroversial, so it’s really more about the messaging," said Soeren Radde, head of European economic research at Point72.

Key Questions for the Markets:

1. What will the ECB announce on Thursday?

A 25-basis-point cut to the deposit rate seems almost certain, with market participants keenly looking for guidance on what comes next. Since the last ECB meeting, traders have fully accounted for another rate cut after September, likely in December, and there are speculations about a potential cut in October as well. These expectations held firm even after Friday’s U.S. jobs data diminished the likelihood of a significant rate cut by the Federal Reserve this month. In mid-July, these expectations were less robust, highlighting the market’s eagerness for any insights from ECB President Christine Lagarde about a potential October decision.

1. Can the ECB ease its inflation concerns?

Currently, more than ever during this economic cycle, the ECB seems to be grappling with inflation. Inflation, which reached 2.2% in August, is the closest to the ECB’s 2% target since 2021, and wage growth is decelerating. With a sluggish economic recovery and a contraction in Germany’s economy during the second quarter, some policymakers warn that a slow approach to cuts could risk pushing inflation below the target. However, economists believe the recent decline in inflation is primarily due to energy and goods prices, which might have peaked. The ECB projects inflation to rise to 2.5% by the end of the year. Core inflation remains just under 3%, and inflation in services has consistently been above 4%. This ongoing inflationary pressure prompts some members to advocate for further easing to ensure inflation remains in check.

1. What will the new ECB projections indicate?

Given that growth has underperformed relative to ECB forecasts in the second quarter, and that underlying inflation appears persistent, analysts expect the bank to lower its growth forecasts and possibly slightly increase its core inflation estimates for this year. Nevertheless, the long-term outlook is expected to remain intact, with the ECB anticipating inflation will return to 2% by late 2025.

1. What are the implications of a stronger euro?

For the time being, the implications of a stronger euro are likely marginal. The euro reached its highest level in over a year in late August, with a strong position on a trade-weighted basis. While a stronger currency could help alleviate inflation, research from the ECB indicates that significant and sustained movements would be necessary to have a meaningful effect.

1. What will the ECB’s restructured rates system entail?

At present, the ramifications of the ECB’s revised rates framework are minimal. The ECB laid out a new strategy in March for managing liquidity while gradually withdrawing substantial amounts of cash from the financial system. This framework includes a reduction in the premium banks pay to borrow at ECB cash auctions relative to deposit interest rates, a change that will first take effect on Thursday. A 25-basis-point deposit rate cut will correspond to a 60-basis-point reduction in the Main Refinancing Operations rate. This adjustment aims to stabilize money markets while encouraging interbank lending. However, with excess liquidity currently around 3 trillion euros, and only a small amount borrowed at recent auctions, it may be years before this change has a significant impact.

Ultimately, details regarding future long-term lending and bond-buying operations will be more critical. Frederik Ducrozet from Pictet Wealth Management emphasized that until the ECB provides clarity on this front, the structure of money markets will remain uncertain.