ECB begins cutting interest rates

We have to go back to the era of Mario Draghi in March 2016, when the eurozone lived with the threat of deflation and the Italian, then president of the European Central Bank, was forced to loosen monetary policy until the price of money fell into negative territory. revitalize the European economy.

Eight years later, the ECB will return to cutting interest rates next Thursday (all indications are that it will be by a quarter of a point), but with a very different economic picture to the previous time.

This will end a cycle of rate hikes that began nearly two years ago to stem runaway price increases that have topped 10% due to the energy crisis and war in Ukraine. Classical economic theory states that lowering interest rates helps stimulate the economy. Credit is cheaper. Financing is more convenient. Demand is increasing. Business profits are growing.

However, there are figures that indicate that the Old Continent does not appear to be in much need of stimulus: the unemployment rate in the eurozone is at a historic low. In April it was 6.4%, and the number of unemployed fell by 100 thousand, falling below 11 million for the first time in the history of the eurozone. Stock markets such as the Dax or Eurostoxx 50 are close to their records.

The inflation rate in the eurozone is 2.4%. The European Central Bank’s goal is to keep it around 2%.

Despite this, the ECB, unless unforeseen events occur, will ease monetary policy. When states are also heavily indebted and the real estate sector shows no signs of crisis. And yet, with the unknown on the table: wage growth in the first quarter was 4.7%. More than expected, and the pace is still high enough to end the possibility of rising inflation or its second-round effects.

Central bankers know that time (and words) are of the essence. If, as many analysts have pointed out, the ECB has been slow to raise rates, would it rush to cut them now? Is there a risk of overheating the economy, which is already healthy?

“I wouldn’t use the word to warm for an economy, a European one, which, although improved, is still quite atonic,” comments Martí Parellada, professor of economics at UB and president of the Barcelona Institute of Economics (IEB). The data shows that eurozone GDP rose 0.3% in the first quarter compared with the previous quarter. Nothing special. In any case, according to ECB chief economist Philip Lane, the impact of the previous rate hike will still be felt in the economy in the coming months. So, in his opinion, the fall now does not risk causing excessive euphoria.

Restrictive monetary policy managed to cool expectations of price increases

In fact, Frankfurt is essentially looking at inflation. Although close to the 2% level, the picture is mixed. It stood at 2.6% in May, thus registering its first recovery since December 2023 and reaching its highest level since February last year. “In this context, among other variables, the ECB must adapt its monetary policy to this failure. Because otherwise real interest rates will remain above 1%, which is high compared to the historical average,” says Roberto Scholtes, head of strategy at Singular Bank.

The ECB may go slower than expected in its cuts given continued wage growth.

There is another reason why ECB President Christine Lagarde can no longer back down. And this is the market consensus. “If now, contrary to all forecasts, the ECB decides to wait before cutting rates, this will send a dangerous signal to investors, contrary to their expectations. You would tell them that inflation is not completely under control or that you know something that investors don’t know. And the reaction can be unpredictable,” admitted an experienced analyst in the corridors of a recent Cercle d’Economia meeting.

Lagarde is aware that unemployment is low and stock markets are high: she can’t exaggerate when things are going down.

As Philip Lane stated, “Keeping restrictive rates in place for too long could lead to lower inflation in the short to medium term, necessitating corrective action by accelerating rate cuts.” In fact, the Bank of Sweden and the Bank of Hungary and the Czech Republic have already begun to reduce the price of money. Now it’s Frankfurt’s turn to make a move.

No one is betting on six money cuts this year, two at most.

And so, one way or another, Lagarde, without imitating Draghi’s mythical “at all costs” (“I will do whatever is necessary to save the euro”), approached her date with history. But, as discussed above, we must recognize that we are moving toward monetary easing rather than true relaxation. A few weeks ago, the eurozone was forecast to see up to six interest rate cuts this year. Now they are talking about two, with the second one possibly targeting September.

The ECB does not trust and moves with leaden feet. There is a table circulating in various research services that attempts to find similarities between the inflation of the early eighties and the current one. Forty years ago, shortly after the first, a second wave occurred. Nobody wants to live in such a situation. “Context has nothing to do with this. At that time, the oil crisis happened,” recalls Angel Talavera, head of European economics at Oxford Economics. Similarly, Scholtes points out that in the eighties, the bargaining power of unions was much higher, and inefficiency was higher and competition was less, so it cannot be compared with that time.

Even Joachim Nagel, the president of the Bundesbank (one of the ECB’s hawks), believes that recent wage increases in the eurozone tend to be a lagging indicator linked to past inflation rates, and sees no obstacle to rate cuts. Without forgetting that the ECB will gradually stop buying debt from member countries. A measure, the last, restrictive, compensating for another. A delicate balance, and only the future will tell whether it was correct.

Well, if everything goes according to plan, who will be able to take advantage of these future discounts? For Scholtes – bags, but only up to a certain point. “Markets have discounted the decline for months. Many companies have borrowed or refinanced their debt at a fixed rate and for a long term, so the drop in their profit and loss statements will be barely noticeable,” he says.

The population will be able to apply for mortgage benefits (the Euribor rate is already expected to decrease), and banks that have returned to business after a long period of financial repression will have to slightly adjust their lending activities.

In an economy like Spain’s, which is growing faster than the eurozone average (2.4% annualized in the first quarter) and which still has a higher inflation rate (this week it was set at 3.6 %), the reduction may likely raise prices. “We need to look at politics as a whole. To begin with, Spain will be able to save on interest payments, and if the reduction leads to increased demand, there will be more incentives and tax revenues, which could be useful for achieving deficit goals,” says Parellada.

Welcome to the new cycle.

Historical balance

About mistakes and successes

Christine Lagarde has completed more than half of her mandate as head of the ECB. Throughout this turbulent period, the country had to contend with soaring inflation and was forced to raise rates to their highest levels since the euro came into force (4%-4.75%). Now that the bearish cycle has begun, can you say that your strategy was correct? Many experts agree that the inflation that has plagued the eurozone over the past two years was not caused by excess demand (minus the recovery from the pandemic), but rather by undersupply of goods due to a long range of factors. Do you remember? Maritime traffic is blocked after the post-Covid imbalance, the closure of gas pipelines due to the war in Ukraine, agricultural harvest failures due to climate change… In this context, acting on demand by increasing tariffs did not seem to be the best course of action. . “But the ECB could not do anything else. Inflation exceeded its target and, even if this was caused by exogenous factors, this should have influenced expectations of higher prices, which ultimately led to higher inflation,” says Angel Talavera, an analyst at Oxford Economics.
It seems clear that Lagarde does not want to repeat the mistakes of another Frenchman in power, Jean-Claude Trichet. Almost 16 years ago, in the summer of 2008, it raised the price of money to 4.25% (close to the current level) as inflation rose to 4%. He did not appreciate the consequences of the collapse of Lehman Brothers: inflation fell sharply, but so did the economy, leading to a full-blown recession. For this reason, Lagarde keeps an eye on inflation when making rate decisions, but also wants to ensure that excessively high interest rates end up, as they did then, unduly depressing the real economy.