Five Questions for the ECB by Reuters

By Yoruk Bahceli and Stefano Rebaudo

The European Central Bank (ECB) is expected to announce a rate cut on Thursday, but the trajectory beyond that remains uncertain. There is a division among policymakers regarding whether the weak growth outlook is sufficient to alleviate concerns about inflation.

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

Here are five key questions for markets:

1. What will the ECB announce on Thursday?
   A cut of 25 basis points to the deposit rate seems almost assured, with market attention focused on future guidance. Following the last ECB meeting, traders have already priced in another cut, likely in December, and some speculate about an October adjustment. In July, there was cautious anticipation of a post-September cut, making investors eager for comments from ECB President Christine Lagarde regarding potential October actions. So far, policymakers have not endorsed consecutive cuts.

2. Can the ECB relax its concerns about inflation?
   Currently, more than at any time in this cycle, inflation reached 2.2% in August, close to the ECB’s 2% target. Wage growth is tapering, and while the recovery in the eurozone has been sluggish—with a contraction in Germany’s economy during the second quarter—there are concerns that a slow pace of rate cuts could risk inflation dropping below target levels. However, economists note that the recent disinflation is primarily linked to energy and goods prices, suggesting that those pressures may have peaked. The ECB anticipates inflation rising to 2.5% by year-end. Persistent core inflation and resilient services inflation above 4% have led more hawkish members to advocate for additional measures to ensure inflation stabilization.

3. What will the new ECB projections indicate?
   With growth in the second quarter falling short of ECB expectations and underlying inflation remaining stubborn, economists expect the bank to lower its growth forecasts and possibly increase its core inflation projections slightly for this year. However, this is unlikely to alter the longer-term outlook, as the ECB still projects inflation returning to 2% by late 2025.

4. What are the implications of a stronger euro?
   The impact appears marginal. The euro recently rose to its highest level in over a year, indicating strength against the dollar and achieving a record on a trade-weighted basis. While a stronger currency could theoretically help manage inflation, it would require significant and sustained movements to make a tangible difference, as highlighted by ECB research.

5. What will the ECB’s revised rate system entail?
   The immediate effects are limited. In March, the ECB introduced a new framework detailing how it would provide liquidity while reducing substantial cash levels in the financial system. To support banks as borrowing needs increase, the ECB lowered the premium for borrowing at its weekly cash auctions. This change aims to maintain stability in the money market while encouraging interbank lending. Nonetheless, the existing excess liquidity of approximately 3 trillion euros contrasts sharply with the mere 2 billion euros borrowed at the last auction, indicating that it may take years for the new system to have an effect.

What may be of greater significance are forthcoming details from the ECB regarding longer-term loan and bond-buying operations, which will be implemented when the central bank’s balance sheet increases again. As Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, noted, "Until that information is available, the structure of the money market remains uncertain."