The European Central Bank’s pivot on interest rates is significant not just because it signals a “turning of the corner” moment in Europe’s two-year long battle against the inflationary shock caused by Russia’s invasion of Ukraine but also because it is the first time Frankfurt has moved to reduce rates before the US Federal Reserve.
The joke is that Frankfurt is full of data-driven economists who don’t lose sleep over rising interest rates while the Fed is controlled by more market-sensitive analysts, who do worry about taking the fizz out of equity markets. The Fed also has a wider remit to protect employment.
But there are bigger structural forces at play than the predilections of policymakers.
At one point early this year, the Fed was forecast to make up to seven interest rate reductions this year but in the face of stubbornly strong inflation, it may now not even make one. Part of the problem is the strength of the US economy which continues to grow strongly despite the Fed’s efforts to slow it down.
ECB policymakers have, in contrast, faced weak or anaemic growth. The euro zone economy fell into a mini recession last year under the weight of stalling demand driven by higher interest rates. Hence Frankfurt rate-setters are perhaps more comfortable lifting the interest rate anvil than their Fed counterparts.
But this transatlantic divergence on inflation may soon begin to narrow again.
[ ECB cuts interest rates by 0.25 percentage points after two years of hikesOpens in new window ]
Headline inflation, for one, quickened more than anticipated in May, accelerating from 2.4 per cent to 2.6 per cent. Wage growth across the EU has also failed to moderate as policymakers would have liked. This explains why price growth in the services sector, where wages play a bigger role, remains a key concern.
The euro zone economy has also rebounded more strongly than expected from last year’s reversal, growing by 0.3 per cent in the first quarter (it had contracted by 0.1 per cent in the previous two quarters). While much of the growth was generated by a bounce back in services, the continent’s troubled manufacturing sector, which has been battered by the surge in energy prices, showed signs of life.
[ Interest rates will remain high, even as the ECB starts cuttingOpens in new window ]
At the post-rate-setting press conference, ECB president Christine Lagarde was asked if Frankfurt had over-committed in signalling a rate cut and was it at odds with increasing the bank’s own inflation forecasts.
She gave a long-winded answer, insisting the bank’s confidence in its projections had grown in recent months. ECB chief economist Philip Lane perhaps gives a better answer to the same question, insisting that inflation and wage growth will “bounce around” this year even if the overall trend is down. Hence policy changes will be measured and limited.
At the start of the year, markets had expected four to five ECB rate cuts, now the expectation is a further two, on top of Thursday’s 0.25 per cent reduction. All of which means the relief for mortgage holders and investors will be limited also.
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