Why Has European Central Bank Cut Interest Rates For One More Time?

With inflation easing, the European Central Bank reduced interest rates on Thursday to support sluggish growth by lowering borrowing costs for companies and homebuyers. The U.S. Federal Reserve is likely to follow soon.

The bank’s rate-setting council decreased the deposit rate from 3.75% to 3.5% during a meeting at its headquarters in Frankfurt. This marks the second rate cut as the bank begins to reverse some of the rapid rate hikes it had implemented to curb double-digit inflation triggered by Russia’s cut-off of most natural gas supplies following its invasion of Ukraine.

However, experts predict that neither the ECB nor the Fed will implement a swift series of rate cuts, and rates are unlikely to return to the low levels seen before the COVID-19 pandemic. Analysts suggest that the ECB will proceed cautiously and may only cut rates once more this year, with inflation falling thanks in part to lower oil prices.

Future European Central Bank rate cuts

Inflation in the 20 euro-using countries dropped to 2.2% in August, close to the ECB’s 2% target, down from a peak of 10.6% in October 2022. At a post-decision news conference, ECB President Christine Lagarde indicated that recent data confirmed their confidence in meeting their inflation target. When asked about the next meeting on October 17, she avoided giving any specific commitment.

Lagarde refrained from providing any further guidance on potential rate cuts, noting that future decisions would be made on a meeting-by-meeting basis, depending on economic data, without committing to a fixed rate path. Policymakers are monitoring inflation in the services sector and rising wages, as workers seek to regain purchasing power lost due to the inflation surge following the pandemic.

The ECB had previously cut rates in June before pausing in July, balancing concerns over sluggish growth, which supports rate cuts, against the need to ensure inflation remains on target, which could justify keeping rates higher for longer.

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Post-pandemic recovery

Consumer prices spiked after Russia cut most natural gas supplies to Europe in February 2022 due to its invasion of Ukraine, leading to higher utility bills. The post-pandemic recovery also caused supply chain bottlenecks, further driving inflation, which spread to services such as healthcare, personal services, restaurants, and entertainment.

The ECB and Fed responded by swiftly raising rates, with the ECB’s benchmark rate reaching a record 4%, later cut to 3.75% in June. These rates influence what banks charge to borrow, affecting rates across the economy. While higher rates cool inflation by making borrowing more expensive, they also slow growth, which is becoming a concern.

Increased rates in Europe and the U.S. have raised mortgage costs for homebuyers and credit payments, but they have benefited savers and retirees by providing higher returns on bank deposits and money market accounts after years of negligible interest.

Fed is expected to make its first rate cut like European Central Bank

The Fed is expected to make its first rate cut at its September 17-18 meeting, reducing its benchmark rate from the current 23-year high of 5.25%-5.5%. Consumer prices rose by 2.5% in August, down from 2.9% in July, marking the fifth consecutive annual inflation decrease. Core inflation, excluding volatile fuel and food prices, remained higher at 3.2%.

Brian Coulton, chief economist at Fitch Ratings, remarked that the Fed’s easing cycle has begun but emphasized that rate-setters would proceed cautiously due to past inflation challenges. He added that the pace of rate cuts would be gradual and monetary easing would not significantly boost growth next year.

Eurozone economy in stagnation

Europe’s growth has remained weak, with a 0.3% increase in the second quarter of this year and an annual rate of around 1.0% based on first-half performance. This follows more than a year of near-zero stagnation. Optimism for stronger growth has been dampened by recent business and consumer sentiment indicators and unfavorable news from Germany, the eurozone’s largest economy.

Germany’s economy contracted by 0.1% in the second quarter, and its outlook remains bleak amid a global manufacturing slowdown. Additionally, long-term issues such as an aging population, a shortage of skilled workers, slow adoption of digital technology, and excessive bureaucracy continue to hinder business growth. Major employer Volkswagen has dropped its no-layoff pledge, which was set to last until 2029, citing the need to reduce costs, and has warned of potential factory closures due to weak demand for electric vehicles in Europe and China.

What is ailing Europe’s economy?

According to Nobel laureate Michael Spence, Europe is facing an innovation deficit and weak productivity, which could lead to economic stagnation unless changes are made. In a Project Syndicate op-ed, Spence mentioned that long-term productivity growth in advanced economies relies on structural changes driven by technological innovation. He pointed out that Europe’s main issue is lagging behind in areas such as artificial intelligence, semiconductors, and quantum computing, where the U.S. and even China are advancing faster.

Europe’s underperformance has persisted for years. In 2008, the GDP of the U.S. and the eurozone were almost the same. However, World Bank data now shows that the U.S. economy is about 75% larger than the eurozone’s. Currency fluctuations have influenced these figures, but when adjusted for purchasing power, EU output has only fallen 4% behind the U.S. over the past two decades. Despite this, even in Germany, Europe’s weakest major economy, consumer confidence remains positive.

At the same time, investors are increasingly acknowledging the era of “American exceptionalism” in the global economy and financial markets. This stands in contrast to Europe, which is increasingly viewed as a hub for leisure, with large numbers of tourists causing frustration among locals due to crowded streets, rising prices, and housing shortages.

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