Still restrictive, but not for long

Central Bank

Summary:

The ECB cut rates by 25bp, but now sees inflation risks more two-sided. More rate cuts lie ahead, but the ECB still seems to be on a path of normalisation and does not appear to be in a hurry on that path. We still see the bottom of rates at 2.25%.

The ECB expectedly cut rates by another 25bp and tweaked its statement while keeping concrete changes limited. The ECB dropped the pledge to keep rates sufficiently restrictive for as long as necessary and instead just said that it is determined to ensure that inflation stabilises sustainably at its 2% medium-term target. Rates are still seen restrictive, but easing financing conditions are already making new borrowing less expensive.

The ECB staff now expects a slower recovery, while the disinflation process is well on track. Changes to the inflation forecasts were moderate, and core inflation is seen at 2.3% in 2025 and 1.9% in both 2026 and 2027, i.e. more or less in line with the target.

The reaction function was kept unchanged and future decisions will still be based on the assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. The ECB is not pre-committing to a particular rate path, while future decisions will be made via a data-dependent and meeting-by-meeting approach.

In light of today’s message, we retain our baseline forecast for 25bp rate cuts at every ECB meeting until April next year, when we see the deposit rate hit 2.25%. Risks remain firmly tilted to the downside for this view.

In the Q&A, Lagarde said there had been discussions on a 50bp cut, but in the end there was a strong rally towards 25bp. She added that while upside inflation risks had not vanished, risks to prices are now more two-sided. Lagarde did not offer any new estimates on where the neutral level of rates might lie, as this topic was not discussed. She said the direction of travel was quite clear, but the pace was not and a lot of ground had already been covered.

Financial markets interpreted the message initially slightly dovishly, but the tone changed, when Lagarde emphasised that a lot had already been done, which markets interpreted as suggesting limited room for further easing. The market is currently pricing in around 30bp of easing for the January meeting, i.e. a clear bias in favour of another 25bp cut. The bottom for the deposit rate is priced at around 1.75%. While financial markets are already pricing in steeper cuts than we have in our baseline, weak data could easily push rate expectations further downwards.

More rate cuts ahead

Lower rates already helping to boost loan demand

Only small changes to the ECB projections

The revisions to the ECB September projections were small, just like expected. Somewhat surprisingly, the ECB expects only 1.1% growth next year compared to 1.3% in September. This was said to be mainly due to weak survey data (PMIs) since the last forecast round. GDP data actually surprised the ECB to the upside in Q3. Thus, the ECB sees that the recovery will be rather weak and it will rely much on higher real income and consumption. The ECB continues to see risks to be biased to the downside and compared to the ECB’s earlier projection rounds, one can consider the 1.3% forecast for 2027 growth to be quite weak.

It seems that in general, the ECB has perhaps lowered its long-term growth potential given that despite the weaker GDP numbers, the revisions to the inflation forecast were very small especially for the core inflation and mainly took place in the short-term.

Inflation is seen to return to the 2% target in the course of 2025 and risks around inflation are to both directions. Inflation can turn out to be sticky if wages continue to rise fast and also trade restrictions can cause cost pressures in parts of the supply chains.

The ECB staff sees inflation returning to the target in the course of 2025

Source:ECB Watch

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