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ECB Review: Cutting and Keeping

Today, the ECB decided to cut its three main policy rates by 25bp, which leaves the key policy rate at 3.75%. This cut follows a 9-month period with unchanged policy rates on the back of the rapid hiking cycle since mid-2022. The rate cut was widely expected and thus focus was on the communication.

The updated staff projections showed inflation to hit 2% one quarter later (Q4 25) than at the time of the March meeting.

With the rate cut fully anticipated, some initial volatility was quickly replaced with markets trading in a tight range, with no commitment on the timing of the next policy rate cut, although the meeting with staff projections (September, December, March, and June) seems preferable with a lot more information provided.

We continue to look for the next policy rate cut in December in our baseline scenario, although we do not rule out a potential rate cut in September.

Acknowledging the progress – not confirming the dialling back phase

The ECB’s decision to cut rates was widely expected by market participants and did not come as a surprise. The decision itself was agreed by most GC members, except one member (Reuters sources reported this to be Holzmann). The staff projections showed an upward revision of growth and inflation this year with a direct reference to inflation still above 2% next year. Coupled with guidance of “keeping” the policy rates restrictive to bring inflation to the target, we maintain our call for the next policy rate cut to occur in December, contrary to market pricing and consensus among analysts who expect a September rate cut.

As discussed in COTW: staying restrictive – not yet entering the dialling back phase, we did not expect Lagarde to confirm that they have entered the dialling back phase, which in our reading would be a commitment to a string of policy rate cuts. When asked about it, she did ‘volunteer’ that we have entered the dialling back phase, although she pointed to a “strong likelihood” of this being the dialling back phase, but she would not confirm this. To us this means that the ECB does not want to pre-commit to a specific meeting or policy rate path. The ECB kept its meeting-by-meeting and data-dependent approach for its threetiered reaction function (inflation outlook, underlying inflation, and strength of the monetary policy). Markets are now pricing an additional 36bp of rate cuts by year-end (on top of today’s rate cut, which takes effect on Wednesday next week).

Staff projections show higher inflation and growth

The ECB expects the economy to continue its recovery as the manufacturing sector stabilises, exports pick up, and monetary policy will exert less of a drag on activity. The updated staff projections show higher inflation both this year and next year due to the persistent pressure from domestic inflation and elevated wage growth. HICP is now expected to average 2.5% in 2024 and 2.2% in 2025, which is 0.2pp. higher than the March projections in both years. Likewise, expectations for core inflation were revised up to 2.8% in 2024 and 2.2% next year from 2.6% and 2.1%, respectively. Lagarde noted that inflation will fluctuate around the current levels for the rest of the year before settling towards the 2% target next year.

The sticky expected inflation outlook is largely driven by the elevated wage growth. The ECB staff expect wage growth of 4.8% this year (previously 4.5%), 3.5% in 2025 (previously 3.6%), and 3.2% in 2026 (previously 3.0%). Lagarde noted that wages will remain elevated, but this is largely due to catching up with previous inflation, while the forward-looking wage tracker shows declining wage pressures. Rising economic activity also adds to inflationary pressures. The GDP growth expectation for 2024 was increased to 0.9% y/y from 0.6%, reflecting stronger-than-expected growth in Q1, as well as marginally higher future growth expectations. The ECB now sees balanced risks to the growth outlook in the short-term, which are changed from downside in March, while all expectations for 2026 were unchanged (see chart).

Danske Bank
Danske Bankhttp://www.danskebank.com/danskeresearch
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