ECB Beats Fed: First Rate Cut in 5 Years

European flags are seen in front of the European Central Bank (ECB) building, in Frankfurt, Germany, on July 21, 2022. (Wolfgang Rattay/Reuters)

The central bank of the European Union went ahead on June 6 with the first rate reduction in its monetary policy decisions since 2019, despite mixed data.

The European Central Bank (ECB), which was broadly anticipated to initiate its first rate cut, lowered three key interest rates by 25 basis points from June 12, which will decrease the rate on refinancing operations to 4.25 percent, while rates on the marginal lending facility and deposit facility were cut to 4.5 percent and 3.75 percent, respectively.

This reduction marks the first cut for the main refinancing operations rate and the marginal lending rate since March 2016. For the deposit rate, it’s the first cut since September 2019.

“Based on an updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady,” Christine Lagarde, president of the ECB, said while addressing the media after the announcement.

With this rate cut, the EU became the second major global economy to reduce its lending rate last week, following Canada’s decision on June 5. This move also aligns with earlier monetary policy easing by central banks in Brazil, Mexico, Chile, Switzerland, and Sweden this year.

Meanwhile, the ECB has gained a head start over the Bank of England and the U.S. Federal Reserve, both of which are likely still months away from making similar cuts.

“Price pressures have weakened, and inflation expectations have declined at all horizons,” Ms. Lagarde said, adding that the ECB intends to keep policy rates sufficiently restrictive for as long as necessary to achieve its targeted level of inflation. “We are not committing to a particular rate path.”

The ECB president also noted that inflation had decreased sufficiently to allow the central bank to begin lowering rates. However, with eurozone inflation expected to stay above the ECB’s 2 percent target into the next year, she refrained from specifying the speed or magnitude of future rate cuts.

However, the ECB confirmed its plans to decrease the euro system’s holdings of securities under the pandemic emergency purchase program (PEPP) by an average of 7.5 billion euros ($8.17 billion) per month in the second half. The approach to reducing PEPP holdings will largely mirror the methods used under the asset purchase program.

Persisting Price Pressure

The ECB has also increased its inflation forecasts for this year and next, emphasizing that any further rate cuts would hinge on upcoming data. The bank reiterated the necessity of maintaining borrowing costs at sufficiently high levels to control price growth.

“Despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year,” the ECB president said.

The ECB revised its forecasts for headline and core inflation in 2024 and 2025 upward from March projections. The central bank now expects headline inflation to average 2.5 percent in 2024, 2.2 percent in 2025, and 1.9 percent in 2026.

The central bank also predicts that inflation, excluding energy and food, will average 2.8 percent in 2024, 2.2 percent in 2025, and 2 percent in 2026. However, the region’s economic growth could accelerate to 0.9 percent in 2024, 1.4 percent in 2025, and 1.6 percent in 2026, the ECB said.

Will the US Fed Follow?

As the European central banks adopt a more accommodating stance compared to the U.S. Federal Reserve, anticipation has started to soar for a similar action from the Fed in its policy-making meeting of the Federal Open Market Committee on June 11 and 12.

Higher U.S. interest rates would tighten global and local financial markets, even though a widening interest rate differential between the two regions may theoretically cause the euro to lose value versus the dollar, making European exports more competitive for the foreign market.

Aside from that, a falling euro would cause the spread between government bond yields to grow, causing bond prices to rise faster in the eurozone than in the United States. This is attributed to the inverse relationship between bond prices and yields.

On the other hand, government stimulus, pandemic recovery spending, and stronger growth are driving inflation in a different economy that the Fed is dealing with.

With an annual rate of 3.4 percent, the U.S. consumer price index is well off the Federal Reserve’s target rate of 2 percent.

Meanwhile, market indicators suggest that the Fed may proceed toward a decision on its own schedule. The euro saw an uptick, with the euro/U.S. dollar pair climbing to almost 1.09. Sovereign bond yields in the eurozone also rose, although European equities pared back some of their earlier gains, even as the Euro Stoxx 600 index hit record highs on June 6.

In other words, according to CME FedWatch, the markets are pricing a zero percent likelihood of the Fed lowering its rates this month.