The ECB's interest rate cut in June was fixed, but Deutsche Bank believes that the ECB is still plagued by high inflation, weak growth, upward pressure on wages, and exchange rate fluctuations. It is expected that it will not cut interest rates month by month but only once every quarter.
After maintaining high interest rates for 22 consecutive months, the ECB's much-anticipated interest rate cut cycle has finally arrived. At the monetary policy meeting on June 6, the ECB will launch the first shot of major central banks cutting interest rates.
According to the latest survey, economists have determined that 100% of the ECB will cut interest rates by 25 basis points on the day of the monetary policy meeting. This expectation is highly consistent with the strong dovish signals released by ECB officials in recent months. More than 2/3 of the economists participating in the survey also believe that the ECB will cut interest rates once each at the September and December interest rate meetings.
Overall, however, the ECB is expected to cut interest rates very prudently, and will not provide much forward-looking guidance. The exact pace still needs to be determined depending on the data. The Federal Reserve's maintenance of high interest rates also forces the ECB to weigh the impact of interest spreads on the exchange rate.
The ECB is likely to cut interest rates very slowly
However, although the ECB started cutting interest rates earlier than the Federal Reserve, the market still has major differences over the ECB's future pace of interest rate cuts.
Mariano Cena, senior European economist at Barclays Bank, said:
Faced with rising uncertainty and the acceleration of economic activity exceeding expectations, we now believe that the ECB will act more gradually this year. The ECB will maintain a gradual pace of progress even if the risks facing the inflation outlook from this year onwards are more symmetrical or even downward.
Deutsche Bank also stated in its latest report:
We believe that reconciling the upward CPI in May will not prevent the ECB from cutting interest rates on June 6. The overall harmonized CPI was 0.1 percentage points higher than expected, at 2.6%. The core harmonized CPI was 0.2 percentage points higher than the consensus, to 2.9%. However, it can be said that this exaggerates the surprise, and the ECB is likely to keep a distance from these data.
The bank also stated:
The ECB has predicted that this year's anti-inflation process will “fluctuate” or be bumpy. The core harmonized CPI will be 2.8%, excluding a one-time change in French medical prices. The ECB also believes that wage growth is peaking and that future service sector inflation is expected to decline.
Judging from the current data, there is no need to quickly adjust the interest rate level. The “last mile” of fighting inflation will be slower, but it will definitely be completed in 2024.
Judging from the data, economic fundamentals in the Eurozone are one of the main pressure factors. Although GDP grew by 0.3% in the first quarter, which was better than expected, the annual growth rate is expected to be only 0.7%, and future prospects are still very uncertain. Furthermore, despite recent positive signs of inflation data, it is not expected to fall back to the target level of 2% until the third quarter of 2025.
Adding to the situation is the pressure on wage growth brought about by strong employment data. According to the data, the Eurozone wage growth rate will remain above 3% for the next few years, higher than what the ECB believes is in line with the 2% inflation target, which may keep inflationary pressure unmitigated for a longer period of time.
The ECB's policy independence is limited and will still be influenced by the Federal Reserve
According to Deutsche Bank's judgment, given the current economic outlook and uncertainty about wage growth, the ECB may be unwilling to provide too much forward guidance and “over promise” on the policy path:
One of the key messages we expect the ECB to send on June 6 is policy selectivity (meeting by meeting, depending on the data). Although the staff's macro predictions can be said to be consistent with the normalization of future policy positions, actual data may deviate from predictions. The ECB does not want to be overly committed to any particular policy path, even if the potential direction — normalization — has implied (and conditionally) signaled.
In terms of the inflation outlook, the bank expects:
Employment growth is forecast to rise 0.2 percentage points to 0.8% in 2024. The core harmonized CPI forecast for 2024 will rise 0.2 percentage points to 2.8%. We expect the core harmonized CPI to rise 0.1 percentage points to 2.2% in 2025 due to a slight increase in unit labor costs.
More importantly for policy, the 2026 inflation forecast should remain the same, and the headline and the end point of the core inflation trajectory are expected to remain at 1.9%, slightly below the target.
Looking ahead to the monetary policy path after the first interest rate cut in June, Deutsche Bank stated:
Our baseline assumption is to cut interest rates by 25 basis points every quarter until interest rates fall to neutral. The bigger picture is that the economy is rebalancing after experiencing a series of large-scale supply-side shocks. Growth is rising, inflation is falling, the second-round effects have been controlled by restrictive monetary policies, and the door to easing restrictions is opening.
Regarding the end of the interest rate cut cycle, Deutsche Bank predicts that in the absence of a negative impact from demand, the ECB will normalize its policy position, that is, remove restrictions, but neutral interest rates may rise:
In a world of increased investment (green transformation, digital transformation, strategic autonomy), there are good reasons to believe that neutral interest rates are rising. ECB official Schnabel recently said that the neutral interest rate could be “well above” 2%.
With the Federal Reserve still maintaining high interest rates, the ECB's decision to cut interest rates in June will reflect its independence. Deutsche Bank believes that the ECB will cut interest rates three times this year (June, September, and December, respectively), while the Federal Reserve may only cut interest rates once in December. If the Federal Reserve's high interest rate policy boosts European yields through arbitrage trading, the ECB may take steps to offset this impact to keep monetary conditions stable.
However, the bank believes that the ECB's independence is conditional, and the future may be affected by various factors, including growth in domestic demand, changes in profit margins, and adjustments in policy interest rates:
Although the euro exchange rate has not depreciated and is at a high level in trade-weighted terms, the ECB still needs to consider the potential impact of exchange rate changes on inflation when formulating policies.
In the next 6 to 12 months, if the difference in policy interest rates between the Federal Reserve and the European Central Bank increases to a historically high level, then the depreciation of the euro may have a strong transmission effect on inflation.
In addition to inflation and economic prospects, the ECB must also weigh the impact of exchange rate fluctuations when making interest rate decisions. On the one hand, the continued weakness of the euro against the US dollar is beneficial to curbing import inflation; on the other hand, it may also cause domestic prices to rise by stimulating exports.
ECB officials are divided on this. Bank of Italy Governor Fabio Panetta acknowledged on Friday that interest rate cuts posed a monetary policy risk to inflation, but he added that US austerity policies may also curb global demand and limit the level of inflation in the Eurozone.
Such internal differences also reflect the tremendous pressure that exchange rate trends have placed on ECB decisions. Generally speaking, interest rate cuts drive the depreciation of the euro, help curb import inflation, and are in line with the ECB's policy goals, but excessive depreciation may also lead to a recovery in inflation within the Eurozone. Under the current circumstances, the Eurozone's current account surplus and higher monetary policy interest rates should have supported the euro's bottoming out, but the influence of the US dollar may disrupt this pattern.
Overall, multiple problems such as high inflation, weak growth, upward pressure on wages, and exchange rate fluctuations caused the ECB to face difficult choices on the eve of the June interest rate decision. The new round of economic forecasts and monetary policy reports released by the ECB at that time, as well as President Lagarde's press conference, will all provide key clues for the market to grasp the future direction of the ECB's policy.
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