ECB to Kick Off Rate Cut Cycle Next Week

After maintaining high interest rates for 22 consecutive months, the much-anticipated European Central Bank (ECB) interest rate cut cycle has finally arrived. At the monetary policy meeting on June 6th, the ECB will fire the first shot in the interest rate cut by major central banks.

The latest survey shows that economists are 100% certain that the ECB will cut interest rates by 25 basis points on the day of the monetary policy meeting, an expectation that is highly consistent with the strong dovish signals released by ECB officials in recent months. Over two-thirds of the economists surveyed also believe that the ECB will cut interest rates once each at the September and December interest meetings.

However, overall, the ECB's interest rate cut pace is expected to remain very cautious, and it will not provide too much forward guidance. The specific pace still needs to depend on the data. The Federal Reserve's maintenance of high interest rates also forces the ECB to weigh the impact of interest rate differentials on exchange rates.

The ECB's interest rate cut pace may be very slow.

Nevertheless, although the ECB started interest rate cuts earlier than the Federal Reserve, there is still a significant divergence in the market regarding the ECB's future pace of interest rate cuts.

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Barclays Bank Senior European Economist Mariano Cena said:

Faced with rising uncertainty and economic activity accelerating beyond expectations, we now believe that the ECB's actions this year will be more gradual. Even if the risks to the inflation outlook become more symmetrical or even downward after this year, the ECB will maintain a gradual pace.

Deutsche Bank also said in its latest report:

We believe that the upward movement in May's harmonized CPI will not prevent the ECB from cutting interest rates on June 6th. The overall harmonized CPI is 0.1 percentage points higher than expected, at 2.6%. The core harmonized CPI is 0.2 percentage points higher than the consensus, at 2.9%. However, it can be said that this exaggerates the surprise, and the ECB may keep a certain distance from these data.

The bank also pointed out:The European Central Bank (ECB) has anticipated that this year's disinflation process will experience "volatility" or "bumps," with core harmonized CPI at 2.8%, excluding a one-time change in French healthcare prices. The ECB also believes that wage growth is reaching its peak, and future service sector inflation is expected to trend downward.

Based on current data, there is no need for a rapid adjustment of interest rate levels. The "last mile" of disinflation will be slower, but it is certain to be completed by 2024.

From the data, the eurozone's economic fundamentals are one of the main pressure factors. Although the first quarter GDP growth of 0.3% was better than expected, the annual growth is only expected to be 0.7%, and the future outlook remains highly uncertain. Moreover, despite recent positive signs in inflation data, it is not expected to fall back to the 2% target level until the third quarter of 2025.

Adding to the woes is the pressure on wage growth due to strong employment data. The data shows that the eurozone's wage growth rate will remain above 3% in the coming years, higher than the level the ECB considers consistent with a 2% inflation target, which could prolong the relief from inflationary pressures.

The ECB's policy independence is limited and will still be influenced by the Federal Reserve.

Deutsche Bank assesses that, considering the current economic outlook and uncertainties in wage growth, the ECB may be reluctant to provide too much forward guidance and "overcommit" on the policy path:

We expect a key message from the ECB on June 6th to be policy selectivity (meeting by meeting, data-dependent). Although the staff's macroeconomic forecasts can be said to be consistent with the normalization of future policy stances, actual data may deviate from forecasts. The ECB does not want to be overcommitted to any specific policy path, even though the underlying direction—normalization—has already been signaled (and conditionally).

In terms of inflation prospects, the bank estimates:

The employment growth forecast for 2024 will rise by 0.2 percentage points to 0.8%. The core harmonized CPI forecast for 2024 will increase by 0.2 percentage points to 2.8%. We expect that, due to a slight increase in unit labor costs, the core harmonized CPI for 2025 will rise by 0.1 percentage points to 2.2%.

More importantly for policy, the inflation forecast for 2026 should remain unchanged, with both headline and core inflation trajectories expected to remain at 1.9%, slightly below the target.Looking ahead to the monetary policy path following the first interest rate cut in June, Deutsche Bank points out:

Our base case assumption is that there will be a 25 basis point rate cut each quarter until interest rates reach neutrality. The bigger picture is that the economy is rebalancing after a series of large-scale supply-side shocks. Growth is rising, inflation is falling, and second-round effects have been contained by restrictive monetary policy, with the door opening to easing restrictions.

Regarding the end of the rate-cutting cycle, Deutsche Bank predicts that, in the absence of negative demand shocks, the European Central Bank (ECB) will normalize its policy stance, which means eliminating restrictions, although the neutral interest rate may rise:

In a world of increased investment (green transition, digital transition, strategic autonomy), there are compelling reasons to believe that the neutral interest rate is on the rise. ECB official Schnabel recently stated that the neutral interest rate might be "far above" 2%.

Against the backdrop of the Federal Reserve maintaining higher interest rates, the ECB's decision to cut rates in June will demonstrate its independence. Deutsche Bank believes that the ECB will cut rates three times this year (in June, September, and December), while the Federal Reserve may only cut rates once in December. If the Federal Reserve's high-interest-rate policy raises European yields through arbitrage transactions, the ECB may take measures to offset this effect in order to maintain stable monetary conditions.

However, the bank believes that the ECB's independence is conditional and may be influenced by a variety of factors in the future, including domestic demand growth, changes in profit margins, and adjustments to policy interest rates:

Although the euro exchange rate has not depreciated and is at a relatively high level in trade-weighted terms, the ECB still needs to consider the potential impact of exchange rate fluctuations on inflation when formulating policy.

In the next 6 to 12 months, if the policy rate differential between the Federal Reserve and the ECB increases to historically high levels, the depreciation of the euro could have a strong transmission effect on inflation.

In addition to inflation and economic prospects, the ECB must also weigh the impact of exchange rate fluctuations when making interest rate decisions. On the one hand, a persistently weak euro against the dollar could increase import inflation; on the other hand, it could also lead to domestic price increases by stimulating exports.

There is disagreement among ECB officials on this issue. The Governor of the Bank of Italy, Fabio Panetta, acknowledged on Friday that rate cuts pose a monetary policy risk to inflation, but he added that the United States' tightening policy could also suppress global demand, limiting inflation levels in the eurozone.These internal divisions also reflect the immense pressure that exchange rate trends place on the decision-making of the European Central Bank (ECB). Excessive devaluation could lead to a resurgence of inflation within the Eurozone. Under current conditions, the Eurozone's current account surplus and higher monetary policy interest rates should support the euro's bottoming out, but the influence of the US dollar could disrupt this pattern.

Overall, the multiple concerns of high inflation, weak growth, wage pressure, and exchange rate fluctuations present the ECB with a difficult choice on the eve of its June interest rate decision. The new round of economic forecasts and monetary policy reports released by the ECB at that time, as well as the press conference by President Christine Lagarde, will provide key clues for the market to grasp the future direction of the ECB's policies.