ECB rate cut to breathe life into Eurozone economy

The Eurozone is set for a much-needed economic boost on Thursday when the European Central Bank is expected to start cutting interest rates for the first time in almost five years. 

The scale of the impetus will depend on how much further borrowing costs fall, but stubbornly high inflation driven by rapid wage growth could limit the number of rate cuts, analysts say.

With markets regarding a first rate cut as a given, investors will be intently looking for clues from ECB president Christine Lagarde to the future path of monetary policy.

By starting to lower rates again, the bank is set to breathe fresh life into housing markets, business investment and consumer spending. The ECB last year raised its benchmark deposit rate to a record 4 per cent, putting a chokehold on economic activity to tackle the biggest price surge for a generation.

“Lower rates do matter,” said Holger Schmieding, chief economist at German bank Berenberg. “Financial markets are well aware this is coming, but news that the ECB has started to cut rates could draw [the] attention of households and businesses, and lift sentiment.”

The Eurozone economy already showed tentative signs of a recovery in the first three months of this year, when gross domestic product in the bloc rose 0.3 per cent from the previous quarter — ending a year of stagnation.

The growth spurt mostly reflected the fading-out of an energy and food price shock triggered by Russia’s full-scale invasion of Ukraine and a pick-up in global trade, Schmieding said.

But he added that the anticipation of rate cuts had also helped to lower the cost of mortgages and corporate loans. “This will lead to a bottoming-out in housing markets, a recovery in housebuilding, and should help investment to recover, as we expect it to this year.”

In Germany, house prices fell 10 per cent after the ECB started raising rates in 2022. But this year they are stabilising after 10-year mortgage rates dropped from almost 4 per cent last October to below 3.2 per cent, according to mortgage broker Dr Klein. 

“The more favourable interest rates since then have led to a noticeable increase in demand for mortgage financing, and the market has experienced a significant upturn since then,” said Michael Neumann, Dr Klein’s head of private clients.

Marc van der Lee at the Dutch association of estate agents predicted that house prices in the Netherlands would rebound to record highs in the second quarter, mainly reflecting rising wages and a shortage of housing, but also lifted by lower mortgage costs.

As for further moves after Thursday’s meeting, the problem for Lagarde is that the steady fall of inflation from its peak of more than 10 per cent in 2022 has been interrupted. Data published last week showed that annual price growth accelerated again to 2.6 per cent in May from 2.4 per cent a month earlier.

The Eurozone’s unexpectedly strong labour market is also keeping price pressures high, with collective wage growth rising back to a record pace of 4.7 per cent in the first quarter, and unemployment in the bloc falling to a new low of 6.4 per cent in April.

Most economists think the recent strong data means the ECB will have to slightly lift both its inflation forecast of 2.3 per cent for this year and its GDP growth prediction of 0.6 per cent.

Combined with signs that the Federal Reserve is unlikely to start cutting rates for several months — if at all this year — as a result of a strong US economy, investors have scaled back their bets to fewer than three quarter-point cuts by the ECB this year.

The timing of this week’s rate cut will be unusual for the ECB because it usually only launches such monetary easing in response to a crisis, such as after the collapse of Lehman Brothers in 2008 or when Greece needed a series of bailouts in 2011. 

Even the ECB’s last rate cut in September 2019 was a reaction to weakening growth and inflation dropping below its 2 per cent target.

“They are cutting into an improving situation, rather than a deteriorating one,” said Paul Hollingsworth, chief European economist at French bank BNP Paribas. “This means they will be in no rush to cut rates further, which makes another cut in July unlikely and steers them towards only cutting once every quarter.”

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Influential members of the ECB’s rate-setting governing council have already hinted they expect a gradual pace of easing, with only two further rate cuts likely this year.

ECB chief economist Philip Lane told the Financial Times last month that rates were likely to “move down somewhat” over the year while staying in “restrictive territory”, which most economists assume means remaining above 3 per cent.

Dutch central bank chief Klaas Knot told an event in London last week that based on the ECB’s latest forecasts its models showed “the optimal policy would have been broadly in line with three to four rate cuts” by year-end.

For inflation to fall to the ECB’s 2 per cent target by next summer, it is counting on a combination of slowing wage growth, increasing worker productivity and shrinking company profit margins.

If these trends fail to materialise and inflation stays uncomfortably high, Hollingsworth said rate-setters “may have to pause after the first couple of cuts”.

Facing such uncertainty over the economic outlook, Lagarde is widely expected to resist giving much of a sign on the likely policy path, enabling the bank to preserve maximum flexibility on the extent of rate cuts for as long as possible.