Data-dependent ECB cuts its interest rates for fourth time in a row
Decision in line with expectations
At its policy meeting on 12 December, the ECB cut its policy rate, the deposit rate, by another 25 basis points to 3%, as expected. As a result, the refinancing rate and marginal lending rate automatically fell along with it by 25 basis points to 3.15% and 3.40% respectively. The decision was in line with KBC Economics and market expectations.
The ECB also confirmed that from January 2025 there will be an end to the reinvestment of assets at maturity from its PEPP portfolio. Eurozone banks will also repay the outstanding amounts of their TLTRO loans (targeted long-term loans by the ECB to banks) this month (December 2024), completing this part of the ECB's balance sheet normalisation. Finally, the ECB also referred again to its TPI policy instrument, which is available if the transmission of its policy would be compromised by interest rate differentials between EMU governments that are considered unreasonably high.
Motivation
The main motivation for the fourth interest rate cut in a row was the ECB's assessment that the disinflation process in the euro area remains on track. For that assessment, the ECB relies on the new December outlook from Eurosystem economists. According to those forecasts, the inflation path for 2024 and 2025 in the euro area will be 0.1 percentage points lower than in the September outlook (at 2.4% and 2.1% respectively in December), unchanged at 1.9% in 2026 and rising slightly to 2.1% in 2027 when EU Emissions Trading System comes into force. ECB president Lagarde stressed that this is the sixth time in a row that the inflation outlook for 2025 is converging towards the 2% target. She considered that a strong argument for the policy rate cut to 3%.
Eurosystem economists expect this disinflationary path against the backdrop of a weakening economic recovery. Real GDP growth in the euro area is likely to be lower in the years 2024, 2025 and 2026 than in the September forecast, at 0.7% (versus 0.8%), 1.1% (versus 1.3%) and 1.4% (versus 1.5%), respectively. In 2027, expected growth is 1.3%.
According to the Eurosystem, the expected economic recovery would be mainly driven by domestic demand, more specifically private consumption (via higher real wage growth) and investment. Exports could also contribute to that recovery, if not hampered by a possible escalation of trade conflicts. For clarity, ECB President Lagarde added that possible effects of trade conflicts are not yet included in the baseline scenario, but are identified as a risk. So if those trade conflicts were to effectively occur, which is not unlikely, it could well mean that the Eurosystem's growth and inflation forecasts are too optimistic (in the sense of overestimating growth and underestimating inflation).
Data-dependency remains, with no precommitment
ECB president Lagarde also confirmed the data-dependence of ECB policy and the principle that decisions are taken from meeting to meeting. In other words, there is no question of the ECB committing to the timing or size of future policy decisions. In the run-up to the December meeting, there were voices advocating such a return to a traditional, more forward-looking policy with more forward guidance and less data-dependence. Such forward guidance could, among other things, reduce volatility in the interest rate market, but the ECB, at least until further notice, wants to preserve all its policy options and will not go into that.
"The ECB is not a jack-of-all-trades"
The ECB president avoided the question of the neutral policy rate, in other words the level at which the policy rate neither stimulates nor slows down economic growth. She did indicate that the policy rate is still restrictive at present. As for the objective of ECB policy, she was clearer though: the ECB's mandate is to pursue price stability, creating a favourable framework for growth. In her view, it is not the ECB's role, in a context of price stability, to stimulate economic growth itself by lowering policy rates below the neutral level (wherever that neutral level may be exactly). Every policymaker has their responsibilities, by which (in our view) she was mainly referring to fiscal policymakers. "The ECB is not a jack-of-all-trades".
Market reaction and KBC scenario
The initial impact of the policy decision on 10-year German bond yields was limited. It initially fell slightly from around 2.15% to 2.13%. However, during the press conference, and particularly after Ms Lagarde's comment that it was primarily up to other policymakers to stimulate growth, the German 10-year rate picked up again to around 2.19%.
A slight shift was also noticeable in market expectations regarding ECB policy at upcoming meetings. For the January meeting, market expectations remained at a 25 basis point rate cut. For March, the most likely market scenario was initially a larger rate cut of 50 basis points, but the market adjusted that to a smaller move of 25 basis points during the press conference. The expected cyclical bottom did remain unchanged at 1.75%.
KBC Economics expects the ECB to cut its policy rate by 25 basis points at the next policy meetings, reaching the likely cyclical bottom of 2% by mid-2025. That bottom is higher than what the market currently expects. This is consistent with Ms Lagarde's comment above, but also with the KBC inflation outlook (which already takes into account the inflationary impact of the likely trade conflict). Moreover, an excessively low ECB policy rate would put further pressure on the euro exchange rate, leading to more imported inflation. This is a transmission channel that Ms Lagarde also reaffirmed during the press conference.