European Central Bank's Historic Decision: A Shift Towards Monetary Easing
At the beginning of the month, the European Central Bank (ECB) finally decided to rectify its monetary orientation by reducing its key interest rates by 25 basis points. This decision was expected, two years after the start of a record tightening cycle of 10 consecutive rate hikes that brought the eurozone's reference deposit rate to 4%.
This is a historic decision, as it marks the first time the ECB has initiated an easing cycle before the US Federal Reserve, which is usually more "dovish." Moreover, the decision was made despite concerns that above-target inflation (2%) might accelerate again after months of significant moderation. In fact, overall inflation was 2.6% in May, while core inflation, which excludes the most volatile components of the basket (energy and food prices), stood at 2.9% for the same period.
In our view, despite persistent concerns about inflation, this decision marks the beginning of a gradual cycle of interest rate reductions. In this article, we examine the three main factors that support our forecasts.
Firstly, inflation is converging regularly towards the ECB's target, providing a useful summary of credit costs in the eurozone. This indicator combines information on short- and long-term interest rates, as well as credit spreads. The index peaked in mid-2022 and currently stands at levels not seen since the worst of the global financial crisis, when the European economy faced a credit crunch and asset prices plummeted, or during the European sovereign debt crisis.
Furthermore, the ECB has continued to reverse the expansion of its balance sheet, which was implemented during the Covid-19 pandemic to support economic activity. The ongoing "quantitative tightening" will continue to remove liquidity from the financial system, created by extraordinary and temporary measures. The reduction in liquidity and the increase in credit costs will impact credit volumes, which are contracting in real terms and are expected to continue to decline in the coming months, indicating to the ECB that its tightening cycle has been effective.
Finally, the eurozone has just experienced a mild recession in the second half of 2023, and its economic growth performance is expected to remain mediocre. The latest impressions from the Purchasing Managers' Index (PMI) indicate stagnation in economic prospects. The PMI is an indicator that favors new interest rate cuts. Inflation is now just above the monetary policy target. Core inflation, which excludes the most volatile components, provides a more stable and informative view of underlying inflation trends. The peak of core inflation was reached at 7.6% in March last year, after which it began a regular decline, reaching 2.9% in the latest publication. The disinflation cycle is expected to continue, regardless of volatility and unexpected negative data.
Moreover, long-term inflation expectations have stabilized at the 2% target for two consecutive quarters. Controlling expectations is essential for moderating price pressures exerted by companies and wage demands from workers. Overall, with inflation close to the ECB's target and inflation expectations under control, the conditions are ripe for the start of an interest rate reduction cycle.
Secondly, the record tightening cycle of interest rates, as well as the normalization of the central bank's balance sheet, have left financial conditions at exceptionally restrictive levels. The financial conditions index, which provides a measure of the improvement or deterioration of economic activity, has been below or close to the 50-point threshold that separates contraction from expansion. According to this indicator, the Bloomberg consensus predicts a modest real GDP growth of 0.6% this year. Even if we think that eurozone activity may reserve some positive surprises this year, our 0.9% growth projection, less negative, remains well below the long-term growth trend of 1.5%. Therefore, growth is expected to remain well below trend and require some support from the authorities.
In conclusion, the ECB's decision to lower interest rates was supported by the ongoing disinflation cycle and overly restrictive financial conditions in an environment of below-trend growth. We expect the easing cycle to be gradual, in the absence of significant unexpected developments in inflation, with two additional 25-basis-point rate cuts this year, as the ECB continues to monitor price and economic activity developments.