ECB rate cuts are drawing closer

Over the past few months, market expectations about ECB interest rates have been volatile (see Chart 1). In October, after the central bank signalled that policy rates had likely peaked, the three-month interbank rate futures contracts priced in ECB policy easing by mid-2024 followed by further rate reductions to around 3%.

Downward surprises on inflation and growth then led markets to expect the first rate cut as early as March 2024 and then aggressive rate cuts towards 1.75% by Q3 2025.

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

Source: LSEG Data & Analytics and EFGAM calculations. Data as at 04 March 2024.

But at the beginning of 2024 inflation fell less than analysts expected. This, together with cautious ECB guidance, led investors to believe that policy rates will not be reduced before June 2024 and that they will stabilise around 2.50% by the end of 2025.

ECB policy will be driven by the inflation outlook. Notably, although less pronounced than in late 2023, the disinflation trend continued in early 2024 and was stronger than forecast in the ECB’s December macroeconomic projections. Headline inflation stood at 2.6% year-on-year (YoY) in February and core inflation fell to 3.1% YoY, a 23-month low (see Chart 2a).

Chart 2a. Eurozone HICP and PPI inflation (YoY)

Chart 2b. Eurozone inflation (6m avg annualised)

Source: ECB, LSEG Data & Analytics and EFGAM calculations. Data as at 04 March 2024.

Despite market disappointment after the early 2024 data, a further decline in inflation is likely. The producer price index (PPI) of manufacturing goods, which historically leads eurozone Harmonized Index of Consumer Prices (HICP) inflation, has been falling on an annual basis since mid-2023.

Also, the services PPI declined in Q3 2023 from a year before, pointing to a pronounced slowdown in services HICP inflation. However, services HICP inflation remains around 4% YoY and, unlike the other HICP components, has not declined much when looking at the annualised changes over six months (see Chart 2b).

The ECB relates the stickiness of services HICP to past strong wage increases and is concerned that high wage growth could prevent the return of inflation to the 2% target. The marginal slowdown in wages in Q4 2023 and in early 2024 is not seen as indicating that wage inflation has peaked (see Chart 3). Furthermore, it remains to be seen how fast wages will normalise with the unemployment rate at a historic low of 6.4%.

Chart 3. Eurozone wages (YoY)

Source: ECB, LSEG Data & Analytics and EFGAM calculations. Data as at 04 March 2024.

Several ECB Governing Council members have noted the need to be confident that wage increases are easing towards the 3-to-3.5% YoY range that is seen consistent with 2% inflation before interest rates can be cut. As data on Q1 2024 wages will only be available in May, this suggests that the ECB will not ease monetary policy before June.

Future ECB decisions will also consider GDP growth. In the five quarters to the end of 2023, the average growth rate of GDP was zero (see Chart 4). The low composite PMI index in early 2024 points to a high risk of stagnation until mid-2024. In the medium term, a widening output gap will put downward pressure on inflation, perhaps pushing it below the ECB’s 2% target. If so, it would be natural to expect significant policy rate cuts, perhaps larger than markets currently discount.

Chart 4. Eurozone PMI composite and GDP growth

Source: LSEG Data & Analytics and EFGAM calculations. Data as at 04 March 2024.

To conclude, smaller-than-expected declines in inflation and comments by ECB Governing Council members have firmed investors’ views that policy rates will not be cut before June. However, inflation is likely to moderate further as the year progresses reflecting falling input costs and anaemic growth. The ECB's maintenance of tighter financing conditions for longer increases the downside risks to inflation and could lead to larger rate cuts than are currently priced in.