Faiz Ansari, Thomas Nycz, Julien Des Rosiers-Bélair
On January 25th, the European Central Bank (ECB) opted to maintain interest rates at the unprecedented high of 4% and signaled openness to potential rate reductions in the spring, which spurred gains in eurozone stock markets while depreciating the euro’s value. The decision comes amid mixed reactions from analysts, following a notable decrease in inflation from 3.7% in December to 2.9% in January. While some endorse the ECB's cautious approach to meet the 2% inflation goal, others argue that the significant inflation reduction presents an ideal time for rate reductions. Understanding the ECB's rationale for holding rates steady is essential to assess the broader economic implications of such a decision.
Overview
At a Bloomberg News event at the World Economic Forum in Davos, Christine Lagarde, the ECB President, expressed her concerns regarding the potential over-extension of the bank's tightening measures. "I understand the argument that we might be overdoing it, that there could be risks involved," Lagarde remarked. However, she believes that premature rate cuts, necessitating subsequent increases, would be a grave error. The decision to maintain stable rates has minimally impacted markets, with expectations for ECB rate cuts now pushed to April from March and projected to total nearly 150 basis points over the next year, down from 160 basis points previously anticipated. Market forecasts now include six rate cuts for the current year, anticipating substantial policy shifts.
Why cuts might be beneficial
Proposed rate reductions aim to invigorate economic growth by diminishing borrowing costs within the eurozone and boosting consumer expenditure, which has hit record lows following the ECB's intense tightening over the past year. This perspective is bolstered by a recent survey indicating a fall in inflation expectations among households to 3.2%, a decrease from 4.0% (Kitco). Early rate cuts could provide much-needed relief to Europe's languishing economy, which has seen stagnation for over a year, in stark contrast to the U.S. where growth has surpassed 3%. Europe's reliance on exports is being tested by several factors, including China's slowed growth, heightened energy costs and interest rates, intensifying global trade disputes, and the expensive shift towards green energy. Germany, Europe's largest economy, is particularly struggling, with its business sentiment indicator dropping to its lowest since the mid-2020 pandemic, hinting at more immediate challenges. By not reducing rates, the ECB risks exacerbating economic and labor market distress by maintaining elevated borrowing costs unnecessarily. "The sharp decline in activity towards last year's end heightens the danger of the ECB having tightened too much," observes Katharine Neiss, a former Bank of England economist and current chief European economist at PGIM Fixed Income in London. Persistently high interest rates could further depress inflation, potentially revisiting the era of persistently below-target inflation experienced before the pandemic.
Why cuts might pose a problem
In the eurozone, banks have begun lowering borrowing rates, anticipating future ECB rate cuts. For Isabel Schnabel, a notably hawkish member of the ECB’s executive board, this trend underscores the risk of premature policy adjustments. “There’s a strong case for caution in altering our policy stance too quickly,” Schnabel argues. The ECB and its policymakers urge a measured optimism, voicing concerns that rate reductions could inadvertently fuel inflationary pressures anew. They foresee a potential inflationary uptick, driven by the expiration of energy support measures and a recalibration of energy price indices in the eurozone, as significant declines in energy prices are phased out of inflation calculations.
The ECB is thus awaiting a fuller data set before making a decision, with wage negotiation outcomes, expected by mid-spring, being particularly pivotal. The tight labor market, evidenced by a 6.40% unemployment rate significantly below its long-term average of 9.08%, presents a risk of unexpected price surges contributing to inflation. However, Christine Lagarde notes signs of decelerating wage growth in the eurozone, an indicator of progress in the battle against inflation. ECB chief economist, Philip Lane highlights the importance of first-quarter wage settlements, due in May, as a critical factor in determining the timing of potential rate cuts.
The ECB must carefully consider the lag between interest rate adjustments and their effect on inflation. In nations like Belgium, France, Germany, and the Netherlands, where fixed-rate mortgages dominate, changes in interest rates impact loans and mortgages primarily upon their renewal, which may occur infrequently. This scenario is reminiscent of the U.S., where the prevalence of 30-year fixed-rate mortgages means Federal Reserve rate hikes have limited immediate impact on existing mortgage payments, contributing to persistent inflation challenges. Given that mortgage and loan payments constitute significant expenditures for many, the ECB’s strategy must be prudent. The potential for a large segment of the population to renew their mortgages or loans simultaneously could amplify the adverse effects of aggressive rate hikes, particularly in countries with variable-rate loans that adjust over time in response to ECB rate changes.
Geopolitical tensions, such as the ongoing conflict in Ukraine and unrest in the Middle East, add another layer of uncertainty to the eurozone's economic outlook. Moreover, the Red Sea shipping crisis, affecting a substantial portion of global container trade through the Suez Canal, has escalated shipping costs and could, with time, impact the prices of imported goods depending on the crisis's duration and severity. J.P. Morgan Research suggests that this disruption could increase global core goods inflation by 0.7 percentage points and overall core inflation by 0.3 percentage points in the first half of 2024.
Additionally, a recent bond market rally, driven by falling yields and the Federal Reserve's signals of impending borrowing cost reductions, has enabled the ECB to begin winding down its Pandemic Emergency Program by phasing out reinvestments later in the year. This step towards monetary tightening is deemed essential for steering inflation back to the target.
Conclusion
Reflecting on the past year, the eurozone’s economy has slowed significantly due to stringent monetary tightening. The impact of these measures varies considerably among the 20 euro-sharing countries. The ECB’s decision to keep interest rates at 4%, despite declining inflation and mixed market sentiments, exemplifies a cautious and strategic stance. While rate reductions could have invigorated consumer spending and business investments, potentially boosting GDP, they also risked exacerbating inflation through disproportionate demand stimulation.
-Equity Research Team