A strong hint has been given by the European Central Bank (ECB) that it is likely to reduce its interest rates from their current high levels in their next meeting. This comes as the primary economist disregards concerns that this move, preceding a similar action from the US Federal Reserve, might lead to unfavourable consequences. Previously criticised for being one of the final major central banks to raise its rates following the highest inflation spike in a generation three years prior, the ECB now appears to be one of the first poised for rate reduction.
Philip Lane, in conversation with the Financial Times prior to the pivotal June 6th meeting of the bank, expressed confidence that current circumstances warranted the lifting of the top restriction. It is expected by investors that the ECB will reduce its primary deposit rate from its highest ever 4 per cent by a quarter of a percentage point at the coming meeting. This follows Eurozone inflation nearly meeting the 2 per cent target of the bank.
Several central banks – including those of Switzerland, Sweden, Czech Republic and Hungary – have already lowered borrowing costs this year due to decreasing inflation rates. However, among the biggest global economies, rate reductions are not anticipated from the Federal Reserve and Bank of England ahead of the summer, while the Bank of Japan is thought to be inclined to keep increasing rates.
The former Ireland Central Bank head was questioned about if the ECB’s prospective early rate reduction filled him with pride. He responded, “For central bankers, the aim is to be mundane and ideally possess minimal ego.”
He pointed out that a key contributing factor to faster inflation reduction in the Eurozone compared to the US was the more significant impact of the energy crisis following Russia’s Ukrainian invasion. He labelled coping with the war and the resulting energy issue as a significant expense for Europe.
“To ensure gradual inflation reduction, it is crucial that restrictive rates are maintained by ECB policymakers this year,” stated Mr Lane, also expressing his warning about the serious issues and potential pain in mitigating inflation if it were to remain consistently over the bank’s target.
Mr Lane indicated that the central bank’s decisions on reducing borrowing costs in the Eurozone for the year will rely on a careful examination of data to ensure safety and proportionality within restrictive parameters. The governing council, comprising of 26 members, will decide on the proposed rate decision presented by Mr Lane, who is in charge of drafting and presenting these decisions.
The general consensus for the year is that stringent restrictions are still necessary. However, there is room for some downward adjustments within this restrictive setting. This comes despite a recent upsurge in wage growth in the Eurozone at the beginning of the year, near record-high levels. Still, Mr Lane emphasises that an overall deceleration of wages is critical, a fact backed up by the ECB’s wage tracking.
Some experts have voiced concerns that the ECB’s aggressive rate-cutting, diverging from the Fed’s actions, may result in a depreciation in the value of the euro, causing inflation by making imported goods more expensive. While significant currency fluctuations will be taken into consideration by the ECB, Mr Lane downplays these worries noting that currency movement has been minimal. The euro has seen significant recovery against the dollar since its six-month low in April, and it has held its value over the course of the year.
Mr Lane also mentioned that delays in anticipated Fed rate reductions have resulted in a surge in US bond yields, causing a similar effect on long-term yields of European bonds. As this may intensify tightening conditions, the ECB may need to respond with additional cuts to its short-term deposit rate.
Inflation in the Eurozone has dipped from over 10 per cent at its 2022 pinnacle to a nearly three-year trough of 2.4 per cent in April. However, data expected to be released this week predicts a slight increase to 2.5 per cent in May.
Mr Lane indicated that the sizeable cost strain, resulting from swift growth in wages that consequently elevates the price of services, signifies that the ECB needs to maintain a constraining policy up to 2025. “The forthcoming year will bring a distinctive dialogue when we observe inflation nearly reaching its aim, at which point we need to ensure the interest rate aligns with the target,” he stated. In essence, how substantially the ECB decides to trim rates will hinge primarily on its examination of the so-called neutral rate, which is the point at which an economy has balance between savings and investments at favoured levels, with output at optimal levels, and target inflation rate. Though estimates of the neutral rate may fluctuate, according to Mr Lane, it will likely suggest a policy rate around or slightly over 2 per cent. Yet, this could escalate if a robust shift towards renewable energy or immense advancements from generative artificial intelligence stimulate an investment wave. – Copyrighted by The Financial Times Limited 2024.