When could the ECB start cutting rates?

The European Central Bank (ECB) kept interest rates unchanged at its January meeting. Yet away from the headlines, the necessary conditions appear to be falling into place for a shift towards less restrictive monetary policy.

Transitory after all?

For instance, news on price pressures in Europe has been increasingly encouraging in recent months, with core inflation and energy prices continuing to move lower. This has occurred with resilient labour markets and credit lending and sentiment stabilising, leading to a growing suggestion that perhaps inflation was transitory after all. 

Meanwhile, developments have given the ECB governing council increasing confidence that their policy has been working, and has led to a flurry of forecast changes by investors, with the consensus for the first rate cut being brought forward to April-June from September previously.

Until very recently, this shift in investor expectations has been largely at odds with the ECB’s verbal signals implying that a start to the easing cycle won’t occur before the summer. From the ECB’s perspective, while encouraging, inflation was not yet sufficiently low enough for a US Federal Reserve-style ‘dovish pivot’. Yet even the ECB’s mood music now appears to be changing, and our key takeaway from the January meeting is that an April cut is most definitely live as a possibility.

Shifting expectations

So, what’s behind this shift? First and foremost, the December bounce in inflation was less than the ECB expected and does not detract from the disinflationary trend. Inflation expectations are now in line with target and the key message from employment and wage data is that wage growth is slowing, vacancies are falling and rising wages are being absorbed by profits, lessening the risk of renewed upward price pressures. 

Furthermore, the ECB accepts that wage data readings are backward-looking, which seems to downplay the importance of the negotiated wage results they have been pointing to as a reason to keep rates on hold.

ECB President Christine Lagarde did, of course, note potential upside risks to inflation given that the labour market remains resilient and that Red Sea developments could have inflationary impacts, hence her desire to be further along the disinflationary path before sounding the ‘all-clear’ on price pressures. But to my mind this seems to be overly focusing on the year-on-year numbers rather than more recent factors.

In addition, Lagarde did not qualify what she meant by her statement at Davos about moving by June, and did not rule out cutting rates in April when directly asked about it. She also did not want to overplay the improvements in the European Bank Lending Survey. Instead, she continued to state that they were data-dependent rather than calendar-dependent, but their read of the incoming data appears dovish.

Spring in the ECB’s step?

We believe this was a clear attempt by the president to make sure the meeting ended with April still very much live as a possibility for the first rate cut. Whether the intention was for it to be 90% priced in by the market for a 25 basis point cut is another thing, but that is where we are at time of writing, even though the latest inflation expectations data have ticked up, with upwards revisions to the prior month’s as well.

On the basis of this meeting, I’d have to say that April looks like the most likely timing for the start to the ECB’s the cutting cycle, with June at the latest.