Data convince ECB of additional interest rate cut
ECB and markets aligned
At its policy meeting on 17 October, the ECB cut its policy rate (deposit rate) by 25 basis points to 3.25%. Its refinancing rate and marginal lending rate fell mechanically along with it by 25 basis points to 3.40% and 3.65% respectively. The decision was fully in line with recent market expectations. As a result, it therefore had little impact on the German 10-year bond yield, which continued to hover around 2.20%.
Besides the interest rate cut, the ECB also confirmed the implementation of quantitative policy decisions already taken. More specifically, it is shrinking the size of its PEPP portfolio by an average of 7.5 billion EUR per month by not reinvesting all maturing assets. Reinvestments will be stopped completely from the beginning of 2025. In addition, the ECB is also closely monitoring the impact of repayments by banks of TLTRO loans, since such repayments shrink the amount of liquidity available in financial markets. Finally, the ECB again referred to its Transmission Protection Instrument as a means of countering unwarranted spread increases in the EMU government bond market. Against the backdrop of the current fiscal debates in, for example, France and Belgium, that reference gains additional relevance.
Downside risks to growth and inflation
The ECB motivates its interest rate cut mainly with two arguments. First, weaker activity indicators have appeared since the previous policy meeting (and interest rate cut) in September, such as PMI confidence indicators in the manufacturing sector. The ECB does stress that it does not expect a recession for the eurozone as a whole, despite the current weakness in Germany's largest economy. This means that the October rate cut should rather be seen as a kind of 'precautionary measure'.
The ECB also stresses that activity indicators are not an end in themselves for its policy, but only play a role to the extent that they have an impact on expected future inflation. This leads us to the ECB's second argument for a rate cut, namely that the eurozone's disinflationary trend remains on track, according to the ECB. In September, headline inflation fell more sharply than the ECB (and the market) expected to 1.7%, while higher core inflation also fell slightly to 2.7%. A note here is that the sharp fall in headline inflation was due to a sharp negative year-on-year change in volatile energy prices. That effect does not necessarily continue to play out.
The ECB expects to reach its inflation target during 2025. In that context, the ECB warns about the statistical base effects in the year-on-year comparison of the consumer price index HICP, which will play out until early 2025. Assuming no strong negative inflation impulses (month-on-month changes), those base effects will raise inflation almost mechanically through January 2025. The ECB is (rightly) 'looking through' that. Indeed, from February 2025 inflation will fall again for the same statistical reason, at least as long as there are no strong (this time upward) inflation impulses.
The combination of weaker activity indicators and declining inflationary pressures were a sufficient reason for the ECB to cut its policy rate in October. Incidentally, that decision was also almost fully priced into market expectations. That situation did put the ECB in a somewhat difficult position. Had it not cut its interest rate against the strong market expectations, it would very likely have led to rising volatility in European interest rate markets in the short term.
Data dependence and no defined policy rate path
In October, the ECB reaffirmed its data-dependence and its refusal to commit to a defined path for its policy rate. During her press conference, ECB president Lagarde cited the October interest rate cut, which was not really on the agenda at the September policy meeting (i.e. before the publication of disappointing confidence indicators), to illustrate exactly that data-dependence of the ECB. Apparently, in the five weeks between the September and October policy meeting, more new and relevant data were published than initially expected. Moreover, they all pointed in the same direction of weaker growth and lower inflation. This is undoubtedly a fair indication of data-dependence, although growing market conviction may also have played a role in the October interest rate decision.
Outlook
With the ECB's 2% inflation target in sight during 2025, the ECB is apparently shifting to some extent its attention to the eurozone's business cycle. Consequently, we expect the ECB to cut its policy rate by 25 basis points at each of the next policy meetings. It is likely that it will not stop at the level that KBC considers "neutral" (around 2.50%), but that the ECB policy rate will temporarily drop to an accommodative level of around 2% in 2025. Since KBC also does not assume a eurozone recession, this will again be more of a precautionary measure, which can be withdrawn when the European economy picks up again. As a central bank, the ECB cannot do much more than giving this kind of cyclical support with respect to growth. During her press conference, Ms Lagarde therefore rightly referred to the structural recommendations of the Draghi and Letta reports to boost the eurozone's longer-term growth potential.