ECB avoids surprises with widely forecast rate cut

The European Central Bank (ECB) avoided surprising the market on 6 June 2024 by announcing its first rate cut in five years. This move was widely forecast, as Eurozone inflation has made considerable progress toward the Central Bank’s target, slowing from a peak above 10% in 2022 to 2.6% in May.

ECB President, Christine Lagarde, confirmed the view that with Eurozone inflation being under control it is now appropriate to moderate the degree of monetary policy restriction. She announced, “We (the ECB) were today more restrictive in real interest rate terms than in December. We are removing a degree of restriction.”

Having instigated the first cut, the real question now centres around how much the ECB is prepared to diverge from the Federal Reserve (Fed), which has so far left rates on hold. Lagarde stated that patience remains the most appropriate path and that the ECB is not pre-committed to a particular rate path. GDP data for the Euro area shows growth slightly above expectations and services inflation remains stickier than expected, climbing to 4.1% in May from 3.7% in the prior month.

In particular, the ECB will want to have more confidence in the trajectory of inflation in services and wages before easing further. Wage growth is expected to remain elevated and volatile throughout 2024, although the ECB’s wage tracker is signalling that overall wage pressures have moderated since 2023. The latest release saw an increase in negotiated wage growth in the first quarter of 2024 to 4.7% from 4.5% in the fourth quarter of 2023. Germany was the main driver for the stickiness in wages, reflecting the delayed effect of recent wage deals catching up with higher inflation.

Overall, we see the potential for some Fed and ECB divergence on rate cuts. In our view, the risk of importing inflation will be minimal and the ECB could deliver another cut in September, followed by another two cuts by the end of the year. Key variables for coming rates cuts will include signs of easing in wage growth, the assumed recovery in productivity and/or the absorption of higher wage costs through profits.

While this policy divergence could have spillover effects for the FX market, we believe any divergence will be limited as emerging signs of a US slowdown should provide the Fed with enough capacity to commence its own easing cycle shortly.  

In this scenario, bond investors could benefit from appealing yields, regional and curve opportunities driven by the different timing and speeds of Central Banks’ action.