Recent Dovish Shifts in ECB Policy Announcements

ECB likely to focus more on growth going ahead We expect the ECB to continue with its gradual shift to growth over inflation. The German ZEW fell sharply, bringing greater attention to the recent weakening in euro area activity surveys (the expectations component fell to 19.2 in August from 41.8 in July). The Sentix survey flagged such a deterioration, but this latest survey evidence continues to highlight the risk of an economic slowdown and is one of the main reasons why we see a further fall in the euro area composite PMI next week. The PMIs will be keenly observed as they are less influenced by market moves. We do not see an immediate catalyst for a rapid economic downturn with real wage growth still positive and unemployment low. However, as the labour market begins to normalise and real wage growth slows, the risk of a more sedate euro area recovery could rise. Euro area GDP for Q2 2024 was confirmed at 0.3% q-o-q this week. More interesting, however, were the data on productivity, with the ECB having signaled this is a crucial part of its profits, productivity and wages nexus. Stronger productivity growth is an important condition to achieve easing underlying inflation. Productivity growth has been strongly negative since the end of 2022, but in Q2 2024 it rose by 0.1% q-o-q – the first quarter of growth since Q3 2022. The ECB is largely banking on a cyclical improvement in productivity. We think rising profit margins and soft real wage growth have made it more financially feasible for firms to hoard labour. Therefore, as euro area growth improves, we expect output to increase more than inputs, raising productivity. For the ECB, we expect two further 25bp cuts this year and three in 2025, taking the deposit rate to 2.50% by September 2025. However, markets expect a lower terminal policy rate.

The European Central Bank (ECB) is expected to implement a 25-basis point rate cut in June, marking the last “easy” rate cut before a potential divergence in policy opinions emerges. While further rate cuts are likely, the ECB will adopt a more gradual approach thereafter. Key Factors Supporting a Dovish Approach: 1.    US Tariffs: These tariffs exert a disinflationary pressure on the European economy by reducing demand for EU goods and increasing the supply of cheaper Chinese goods. 2.    Weak Labor Market and Wage Growth: Data from countries like Germany show weakening labor market conditions, contributing to a favorable outlook for services inflation. 3.    Disinflationary Forces: Lower oil prices and a stronger euro make imports cheaper, further dampening inflation pressures. Arguments for Pausing/Adopting a more Gradual Approach After June Cut: 1.    Interest Rate Approaching Neutral: With rates already reduced seven times, another 25-basis point cut would bring the ECB’s policy rate to 2%, nearing the neutral rate where policy neither stimulates nor constrains the economy. 2.    Lag in Monetary Policy Impact: Rate cuts take time to affect the economy due to the long and variable lags of monetary policy, questioning the effectiveness of further cuts in addressing short-term risks. 3.    Upcoming Fiscal Stimulus: Fiscal stimulus measures, particularly from Germany, are expected to support economic activity in 2026. Additional rate cuts could add to inflationary pressures once fiscal policies take effect. Uncertainty in Trade Policy: The ECB faces uncertainty due to trade tensions, particularly with the US, and the unknown impacts of tariffs and retaliatory measures. Escalating trade disputes could lead to inflationary pressures, complicating monetary policy decisions. Conclusion: The ECB will likely implement another 25-basis point rate cut in June, followed by a further cut in September. However, the effectiveness of additional cuts is questioned due to the lag in policy impact, ongoing fiscal stimulus, and uncertainties in global trade, making further aggressive cuts less likely in the near term.

The European Central Bank cuts interest rates by 25bps. The ECB lowered its three key interest rates by 25 bps in October 2024, as expected, following similar moves in September and June. The deposit facility, main refinancing operations, and marginal lending facility rates will now be 3.25%, 3.40%, and 3.65%, respectively. This decision stems from an updated assessment of inflation, which shows disinflation progressing well. In September, inflation in the Eurozone fell below the ECB’s target of 2% for the first time in more than three years. While inflation is expected to rise in the short term, it should decline towards the 2% target in 2025. Wage growth remains high, but pressures are easing. The ECB remains committed to restrictive rates to ensure inflation reaches its medium-term goal, using a data-driven, flexible approach without committing to a specific rate path.

Dialling back Next week ECB will meet. Anything but a 25bp rate cut would be a major surprise to markets and analysts. The staff projections should reflect the slight moderation in the labour market and economic activity since the June meeting, and thus fuel confidence in the disinflationary process being on track in light of diminishing topside risks. As a result, we may only see some shifts in the quarterly profile and not a large change to the narrative. In annual figures this may result in minor changes, particularly taken from a market perspective, given the uncertainty of forecasting inflation and the economy two years out. On the communication front, we expect Lagarde to confirm that the ECB has entered the dialling back phase, but importantly that she will add that it is not a commitment to specific timing of further rate cuts nor a specific terminal rate target. That means the ECB is not expected to deviate from the meeting-by-meeting and data-dependent approach to policy rate changes, thus keeping its guidance with optionality and flexibility. This is important also in light of what happens with the US economic outlook, and the risk of spillover to the euro area; flexibility must be seen as essential. Today's chart shows the number of additional rate cuts that markets are pricing for 2024, 2025 and 2026. Markets are currently trading the October ECB meeting at 10bp, which does not offer a great risk / reward in our view. While I still do not anticipate that the ECB will cut in October, markets will likely only price that out after the Fed meeting in two weeks, and thus being active in markets you may have been at risk of hitting a stop loss along the way. We do not find the risk/reward particularly attractive. It is quite interesting though that the market pricing for this year has come somewhat higher (lower October rate cut pricing), but at the same time the 2025 segment has seen slightly more cuts priced in. This shift in pricing of rate cut expectations (and probability mass) from 2024 to 2025 has also been supported by a lower terminal rate / trough point to slightly lower than 2%. Markets are discounting 110bp of cuts in 2025. Markets are inconsistent these days when you compare inflation and €STR swaps. Looking at the inflation fixings for next year, the HICP ex tobacco (tobacco has historically added 0.1pp to inflation fixings) is set to average just 1.64% in 2025 and 1.71% in 2026. This means that the 2025 inflation fixings equate to a roughly 0.13% m/m inflation, and that is very low in our expectations. If the inflation profile that markets are pricing does materialise, we should also assume that €STR swaps should price in significantly more rate cuts than they do currently, and well below the neutral rate level to support the economy. Inflation market pricing is roughly consistent with one of the downside risk scenarios that we discussed last week. Have a great weekend! Full piece in comment