What comes next after the ECB cut rates?

The ECB meeting on 6 June delivered the expected 0.25% interest rate cut. Unlike recent meetings, the ECB did not provide any forward guidance on future monetary policy. The message was rather one of caution on future decisions given the determination to keep interest rates at levels “sufficiently restrictive for as long as necessary” to bring inflation back to the 2% target.

The market took note. Following the Governing Council meeting, the expected interest rate path for the next few quarters moved higher (see Chart 1). Only one more 0.25% interest rate cut is fully priced in by the end of 2024 and the level at which interest rates are expected to settle in the longer run has risen to around 2.70% from 2.30% expected three months ago.

Chart 1. Eurozone 3-month interbank rate implied in futures contracts

Source: LSEG Data & Analytics and EFGAM calculations. Data as at 12 June 2024.

However, this scenario seems overly restrictive. In fact, the latest ECB staff projections see annual inflation returning to 2% by the end of 2025 and falling to 1.8% by the end of 2026. President Lagarde noted that even after the rate cut, the ECB's monetary policy is more restrictive than it was in September 2023, if real interest rates net of inflation over the last 12 months are considered.¹ Lagarde added that interest rates remain "far away from the neutral rate".

It would therefore be surprising if interest rates were not cut in the coming quarters if inflation follows the path projected by the ECB staff.

Chart 2. Eurozone nominal and real short term rates

Source: ECB, LSEG Data & Analytics, and EFGAM calculations. Data as at 12 June 2024.

It is also interesting to note that 3-month interest rates implied by futures contracts seem quite high compared to the ECB’s inflation projections. The implied real rate would be around 1% at the end of 2025 and 0.9% at the end of 2026 (see Chart 2). Such high real short-term rates have been seen only when GDP growth was strong and inflation was above the 2% target.

Furthermore, recent ECB estimates indicate that the neutral real interest rate for the eurozone economy is around zero.² This suggests that there is room for deeper cuts by the ECB than markets currently anticipate.

This conclusion is also supported by the EFGAM Hawkishness Indicator (EHI) for the ECB. The EHI aims to track the policy bias at central bank meetings by counting the number of times key terms such as “elevated”, “robust”, “high”, and “strong” are used in the published meeting minutes. Given the EHI fluctuates from meeting-to-meeting, it is informative to observe its broader trends and, for the ECB, that is one of a meaningfully less hawkish policy bias (see Chart 3).

Chart 3. EFGAM ECB Hawkishness Indicator

Source: ECB, LSEG Data & Analytics and EFGAM calculations. Data as at 12 June 2024.

While the minutes of the June meeting are not yet published and are therefore not reflected in the EHI, the decline in hawkish rhetoric relative to the EHI’s peak in April 2022 is notable. This adds to evidence supporting the view that the ECB will reduce interest rates in the medium term.

In conclusion, the decision to cut interest rates on 6 June was widely anticipated. A cautious message regarding future Governing Council decisions saw markets revise up their expectations for future rates, but, in our view, the scenario priced in may now be overly restrictive. ECB staff inflation projections, high real interest rates and a meaningful decline in hawkish rhetoric all support this argument.

¹ This is the measure of real interest rates that President Lagarde referred to. Another way to compute the real interest rate is using a measure of expected inflation, an approach that could be more appropriate when inflation is changing rapidly.
² See https://go.pardot.com/e/931253/box202401-0772edc611d3-en-html/47b97/382232529/h/DZnkw9AfRZp6_5SQrYr89coIEkgbh_95PtOWgMdSp4M