News & analysis

The European Central Bank joined its peers in Switzerland, Sweden, and Canada by cutting its policy rate by 25 basis points, bringing the deposit rate to 3.75% having held it at a terminal level of 4% for the previous nine months.

This was the most telegraphed start to an easing cycle out of all the G10 central banks to have cut rates so far, with 17 of the 26 members of the Governing Council openly discussing a rate cut in June since April’s meeting. With the decision essentially a “fait accompli” according to Vice President de Guindos back in May, the announcement itself had very little bearing on markets. That said, the euro did receive a marginal bid following the decision.

We think this is mainly attributable to the larger-than-expected upgrade to the 2024 staff GDP projection, which was lifted 0.3pp to 0.9%. In conjunction with staff upgrading their near-term core inflation forecasts, this suggests that there is an increasing risk of inflation persistence stemming from stronger domestic demand conditions, leaving the ECB’s data-dependent stance to be interpreted in a hawkish manner.

Eurosystem staff predict stronger euro area growth and a greater degree of core inflation over the coming 18 months   

That said, policymakers didn’t deem the stronger outlook for domestically driven inflation concerning enough to discourage them to cut rates as ultimately, they still see inflation falling back to target by late-2025.

With their confidence over the overall disinflation trend unwavering since March and the trend-decline in inflation leaving the real stance of monetary policy tighter than earlier in the year, today’s cut was relayed in the context of removing the “top layer” of monetary restrictiveness, a term coined a month earlier by Chief Economist Philip Lane.

This was the message hammered home by President Lagarde in the press conference, where she stressed that the ECB must be “forward looking” and that policymakers were becoming increasingly confident over the projected path of disinflation when justifying the decision to cut.  However, in a somewhat contradictory manner, President Lagarde also highlighted the level of uncertainty that remains around the ECB’s inflation forecasts in an attempt to retain optionality moving forward, stating explicitly that the ECB isn’t entering a “dialling back” phase.

Together, the forward-looking nature of the ECB’s current reaction function, but also the dependency on the data to confirm previous staff forecasts, suggests to us that the ECB are only likely to adjust policy at a quarterly pace should the data follow the forecasts. This would align any decision with fresh staff projections and updated wage information.

This isn’t necessarily too dissimilar to the path priced into EUR rates. Overnight interest rate swaps currently have the ECB easing close to 3 times over the next 9 months, with each cut centred on when ECB staff are set to update their forecasts. We think this is a reasonable assumption and one that is unlikely to be altered over the summer months.

This effectively leaves EURUSD at the mercy of US developments, where we think the Fed’s implied policy path has more room to readjust in the near-term.

Market expectations of ECB easing have aligned with a quarterly pace of cuts delivered at the ECB’s projection meetings  

Author: 
Simon Harvey, Head of FX Analysis

 

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