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The monetary policy loosening cycle has officially begun with interest rate cuts coming from a number of global central banks over the past few weeks, most notably the European Central Bank (ECB), along with Canada, Sweden, and Switzerland. While markets cheered the decision, some argue that the move is premature and is likely to stoke the inflation flames. ABSI this week will focus primarily on the ECB’s recent rate cut decision.

On the 6th of June, the ECB followed the actions of the Bank of Canada to be the second major central bank to cut interest rates, moving them 25bps from 4% to 3.75%. The President of the ECB, Christine Lagarde, cited a material improvement in the outlook for inflation as the underlying reason for the cut. However, the ECB does remain vigilant on inflation and will not pre-commit to a particular rate-cutting path.

EU Interest Rates

Source:  Trading Economics

It is important to appreciate that while most central banks operate a dual, and somewhat conflicting, mandate of price stability and full employment, the ECB focuses entirely on price stability using a 2% inflation target. This makes sense for an economic union sharing the same fiat currency. It also makes the job difficult as you have to account for 20 different inflation rates from the various members who share the Euro currency.

It is interesting to note that on the same day the ECB cut interest rates it also upgraded its own inflation estimates after inflation accelerated in May.

Source:  ECB

To the ECB’s credit, inflation has slowed down enormously since it peaked at 11.5% in October 2022. Since then it has retreated to a low of 2.4% in March and April 2024 and not far off its 2% target. However, in May inflation creeped up to 2.6% and the bank has since upgraded its inflation forecast to 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026. This has resulted in many commenting on the hypocrisy of the ECB cutting rates and upgrading inflation at the same time. 

It appears the ECB is going “off-book” and is looking beyond price stability in making its monetary policy decision. GDP growth is stagnating across the EU economies, with an average growth rate of 0.3% in Q1, alongside a heavy debt burden for many of the weaker economies, known colloquially as the PIGS (Portugal, Italy, Greece, and Spain). In cutting rates, the ECB is making it slightly cheaper for these fiscally illiterate countries to access debt.

Source:  ECB

You may recall the ECB was late to the interest rate hike party back in 2022. When most central banks were raising rates in the face of “transitory” inflation in February/March of that year, the ECB held back and didn’t start tightening until July which resulted in some of the highest inflation rates in the G20. Now they have done an about-face and been one of the first to cut. This could prove costly and embarrassing in the future if inflation continues to climb and they’re forced to reverse course yet again. No doubt the governors of other central banks will be watching the results closely.

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