The long-awaited reduction in interest rates, for the first time since 2019, announced the European Central Bank (ECB). And this is despite inflationary pressures that persist in the 20 euro countries, although inflation has fallen from over 10% at the end of 2022 to just over 2% in recent months.

The ECB cut all three of its key interest rates by 25 basis points. The interest rate on the main refinancing operations as well as the interest rates on the marginal financing facility and the deposit acceptance facility are reduced to 4.25%, 4.50% and 3.75% (from 4% as of September 2023), with effective from June 12, 2024.

The movement of the Central Bank of the euro is considered as the beginning of a relaxation cyclehowever the prolonged pressures on wages and prices cloud the landscape regarding its next moves and decisions.

“The Governing Council will continue to take an evidence-based approach and take decisions from meeting to meeting to determine the appropriate extent and duration of the contractionary change in monetary policy,” the ECB said in a statement.

Markets, however, have discounted another decline this year, while a recent Reuters poll suggests economists are predicting two more cuts (one in September and one in December). It is recalled that at the beginning of the year average estimates predicted 5 interest rate cuts this year. In any case, analysts estimate that persistently high inflation is likely to limit the number of future cuts.

In this context, after all, ECB revised upwards its estimates for 2025 inflation to 2.2% from 2% it previously forecast. And as it says in its statement “despite the progress made in recent quarters, domestic price pressures remain strong as the pace of wage growth is elevated, and inflation is likely to remain above target for much of the next year too.”

Economists estimate that the biggest risk to the timing of interest rate cuts is actually the Federal Reserve, not wages and inflation. The Fed has clearly signaled that it will delay easing its policy. Thus, further delays by the US Federal Reserve are likely to make the ECB more cautious, as a widening of the euro-dollar interest rate differential would weaken the single European currency and increase imported inflation.

It is recalled that the Central Bank of Canada was the first among the G7 countries to cut interest rates (yesterday), while the central banks of Sweden and Switzerland cut their interest rates a few weeks ago.

The decision was almost unanimous

The decision to cut interest rates was almost unanimous – with the exception of one member of the ECB’s board, whom the head of the Central Bank refused to name.

“There was absolute consensus in agreeing that our course would depend on the available evidence, that we would decide on a meeting-by-meeting basis, and there was absolutely no disagreement on that front,” Lagarde told a news conference.

Referring to the reasons why the ECB proceeded today to reduce interest rates, Mrs. Lagarde referred to the good course of the economy. As he explained, the confidence of the ECB has increased and this is because inflation has marked a significant decline. However, he reiterated that the decisions of the monetary policy makers will depend on the available data.

What the European Central Bank says in its announcement

The Governing Council decided today to cut the three main interest rates of the ECB by 25 basis points. According to the updated assessment of the outlook for inflation, the dynamics of core inflation and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy accommodation after nine months of holding interest rates. Since the Governing Council meeting in September 2023 onwards, inflation has fallen by more than 2.5 percentage points and the outlook for inflation has improved significantly. Core inflation has also eased, reinforcing signs that price pressures have eased, and inflation expectations have eased across the board. Monetary policy has kept financing conditions tight. The curbing of demand and the stabilization of inflation expectations have contributed significantly to the return of inflation to lower levels.

At the same time, despite the progress made in recent quarters, domestic price pressures remain strong as the pace of wage growth is elevated, and inflation is likely to remain above target for much of next year as well. The latest Eurosystem staff projections for headline and core inflation arehave been revised upwards for 2024 and 2025 compared to March projections. Experts now expect headline inflation to average 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. As for inflation excluding energy and food itemsforecast to average 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026. The rate of economic growth is expected to accelerate to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026.

The Governing Council is determined to ensure that inflation returns to its medium-term target of 2% in time. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this goal. The Governing Council will continue to take an evidence-based approach and make decisions on a meeting-by-meeting basis to determine the appropriate extent and duration of the contractionary change in monetary policy. In particular, its interest rate decisions will be based on its assessment of the outlook for inflation in light of incoming economic and financial data, the dynamics of underlying inflation and the intensity with which monetary policy is transmitted. The Board of Directors does not commit in advance to a specific course of interest rates.

The Board also confirmed today that will reduce the securities held by the Eurosystem under the Pandemic Emergency Asset Purchase Program (PEPP) by 7.5 billion euros per month on average in the second half of this year. The detailed terms of this reduction will generally be similar to those that applied to the asset purchase program (APP).

Asset Purchase Program (APP) and Pandemic Emergency Asset Purchase Program (PEPP)

The APP portfolio is being reduced at a measured and predictable pace, as the Eurosystem no longer reinvests principal amounts from redeeming securities at maturity.

The Board of Directors will continue to fully reinvest principal amounts from redeeming securities acquired under the PEPP scheme when they expire by the end of June 2024. During the second half of the year, it will reduce the size of the PEPP portfolio by €7.5 billion per month on average. The Board intends to end reinvestments under the PEPP scheme at the end of 2024.

The Governing Council will continue to apply flexibility to the reinvestment of amounts from the redemption of PEPP portfolio securities as they mature in order to address risks to the monetary policy transmission mechanism related to the pandemic.

Refinancing operations

As banks repay the amounts borrowed under targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted financing operations and their continued repayment contribute to the direction of its monetary policy.

Finally, it is noted that the Governing Council of the ECB is ready to adjust all the instruments at its disposal within the limits of the mandate assigned to it, in order to ensure that inflation will return to the 2% target in the medium term and to preserve the smooth operation of the monetary policy transmission mechanism. In addition, the Transmission Protection Instrument (TPI) is available to hedge against undesired, disorderly market developments that pose a serious threat to the transmission of monetary policy across euro area countries, thus allowing the Administrative Council to more effectively fulfill its mission of price stability.