ECB resumes path of interest rate cuts and stresses its data dependence

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The ECB also confirmed the implementation of quantitative policy decisions already taken. Thus, the ECB is shrinking its PEPP portfolio by an average of EUR 7.5 billion per month by not reinvesting all assets at maturity. As of 2025, these partial reinvestments will also be completely discontinued. The ECB also continues to evaluate the impact of banks' repayments of outstanding TLTROs on its monetary policy stance. After all, these repayments remove (excess) liquidity from the financial system.

The resumption of the rate easing cycle by the ECB in September was widely expected by financial markets and was also part of KBC Economics' interest rate scenario. The ECB's decision is consistent with recent macroeconomic indicators for the eurozone, in particular the drop in headline inflation to 2.2% in August. While that decline was driven largely by the temporary effect of a negative year-over-year change in energy prices, the overall disinflationary trend towards the ECB's 2% target remains broadly intact. 

ECB September projection with few surprises

 In their new September macroeconomic projections, ECB economists, as in the June projections, expect inflation to reach the 2% target in the second half of 2025. Annual average inflation expected by ECB economists remained unchanged at 2.5%, 2.2% and 1.9% in 2024, 2025 and 2026, respectively. Behind this is a slightly higher path for underlying core inflation (excluding food and energy) compared to June's projections. Nevertheless, even the annual average core inflation rate will fall to 2% in 2026, according to ECB economists. The slightly higher path for core inflation is offset by a more moderate price path of the energy and food components, according to the ECB economists, leading to an unchanged inflation path on balance as mentioned. In addition, ECB economists revised the GDP growth path slightly downward, in the context of recent weaker activity indicators, especially related to domestic demand.

ECB remains data-dependent and does not pre-commit

Against that backdrop, the ECB remained vague about the further timing and magnitude of the next steps in its easing cycle. It underlines that its further decisions remain fully data-dependent and are (re)considered from meeting to meeting.

That pragmatic data-dependence remains a sensible strategy against the backdrop of still stubborn core inflation (mainly driven by the services component), which reached 2.8% year-on-year in August. However, as also expected by the ECB, core inflation is likely to cool further in the relatively short term. Three factors are likely to play a role in this. The current wage agreements to a large extent reflect a one-off catch-up in real wages relative to the inflation surge of the recent past. Consequently, they are unlikely to be repeated to the same extent in 2025. In addition, declining corporate profit margins play a role of buffer that absorbs part of the higher labour costs. That part is then no longer passed on to final consumer prices. Finally, labour productivity, which is currently quite low in the euro area due to ‘labour hoarding’ during the crisis period, will increase again for cyclical reasons during the expected recovery. Together with the expected moderation of wage increases from 2025 onwards, this is likely to bring the expected development of unit labour costs back in line with the inflation target of 2%.

Keeping an eye on the Fed

The ECB's self-proclaimed data dependence is also largely related to the fact that ECB policy is not independent of the Fed. Indeed, if the ECB were to ease substantially less that the Fed, it would likely lead to a further appreciation of the euro against the dollar. The ECB will want to avoid that negative impact on European growth (via net exports) as well as the additional disinflationary effect. Ultimately, this means that ECB policy will be partly indirectly dependent on US economic data, especially the US labour market, since they help determine Fed policy. The task for the ECB is further complicated by the fact that, as now in September, the ECB has to make its next two interest rate decisions just before the Fed's policy meetings. Hence the ECB's emphasis on its data dependence.   

Outlook

Against the background of the continuation of the disinflationary trend, weaker activity indicators, the upcoming start of the easing cycle by the Fed and the strengthened exchange rate of the euro against the dollar, we expect the ECB to cut its interest rates one more time in December 2024. Whether that will be by 25 basis points (our base case, i.e. to 3.25% by the end of 2024) or by 50 basis points will depend crucially on how sharply the Fed implements its easing cycle starting next week. 

In the first half of 2025, the ECB will cut its deposit rate further, which will bottom out in this interest rate cycle. Again, the ECB reaction will depend heavily on the Fed's interest rate path. The more severe the Fed's easing cycle, the more likely it is that the ECB deposit rate in this cycle will also show a substantial undershooting relative to the fundamental neutral rate. 

Financial markets are currently unsure whether the remaining ECB rate cut in 2024 will be 25 basis points (to 3.25%) or 50 basis points (to 3%). The implicitly priced in financial market probabilities are about 50%-50%, with the balance shifting slightly to 25 basis points during ECB President Lagarde's press conference. That move was also consistent with a net slight increase in the German 10-year yield by a few basis points.