Timing is everything: Will the ECB fail to clear the three percent hurdle?

Analysts and investors are certain that interest rates will fall rapidly from mid-September. But as soon as they reach the critical level, the central bankers will probably be in trouble. Because then everything will be at stake – and they have no plan for what will happen next.

When the monetary authorities of the European Central Bank (ECB) meet next Thursday for the first interest rate meeting after the summer break, it will be pretty clear where things are headed. Economists, investors and analysts all expect that ECB President Christine Lagarde will continue the interest rate turnaround initiated in June and further reduce the key interest rate in the eurozone. After five years, this will significantly reduce financing costs in the economy, and loans for home builders, companies and banks will become noticeably cheaper again.

And the trend continues downward: further interest rate cuts are expected for the meetings in October or December. By the end of the year, the key interest rate should be back at around three percent, and no longer at 4.25 percent as in June. The financial markets have largely priced this in. Anything else would be a big surprise.

But the big question is what happens next. Because when the three percent hurdle is reached, interest rates in the eurozone will reach a critical threshold. From this point on, the silent consensus in the ECB Council is that interest rates must be lowered again after two years of exploding inflation. Because too much is at stake. None of the powerful monetary governors will make a mistake. And so they run the risk of fighting each other in a dispute over direction that could cause serious damage to the euro economy.

The interest rate sound barrier in sight

The path to the three percent hurdle is effectively clear. As the financial agency Bloomberg reported this week, citing anonymous sources, the ECB internally assumes that the key interest rate can be reduced from its current level two to three times “without major friction.” After that, anything is possible – the central bankers are taking a short-term approach.

While they largely agree that there is scope for further interest rate cuts next year, there is major disagreement about how much of a threat rising prices still pose – and whether and how quickly interest rates should therefore fall further below 3 until the inflation rate has reached the stated target of 2 percent again.

The doves in the ECB Council fear that the economy could falter if the central bankers do not step on the gas energetically enough. The hawks, on the other hand, worry that an overly loose monetary policy could fuel the price explosion again because the monetary authority had raised interest rates at a record pace from 2022 onwards.

“The closer the key interest rates come to the upper range of estimates of the neutral interest rate – that is, the less certain we are about how restrictive our policy is – the more cautious we should be to avoid policy itself becoming a factor in slowing down disinflation,” ECB director Isabel Schnabel recently put it succinctly. In other words: The ECB is approaching a dangerous point in time when it will go from being the solution to being the problem. Because it is either too hesitant or too aggressive. And thus stalling or overheating the economy.

Forward without forward guidance

That is why the monetary authorities are keeping their powder dry so far – and keeping all options open. “In the ECB Council, we have stressed that we are not committing ourselves in advance and are making decisions based on the data,” said Bundesbank President Joachim Nagel this week. “We are still not operating on autopilot.”

The first cracks between the doves and the hawks, who are roughly evenly balanced on the board, are emerging. The 26 ECB Council members are divided. The Greek central bank boss Yannis Stournaras, for example, warned: “We should pay equal attention to both exceeding and falling short of the inflation target.” His Portuguese counterpart Mario Centeno agreed with him, saying that the inflation rate must be curbed with the least possible damage to the economy. Bundesbank chief Nagel, on the other hand, stressed that “a timely return to price stability cannot be taken for granted.” “We must therefore be cautious and not lower the key interest rates too quickly.”

Timing is also everything. The difficulty is that the right point in time at which interest rates no longer dampen inflation but instead fuel it cannot be determined objectively. It lies within a certain range and thus remains a matter of opinion to a certain extent. And in doing so, central bankers are currently giving the financial markets what they hate most: a lot of uncertainty.

Normally, the monetary authorities more or less give away where things are headed. Even if this guidance, known in technical jargon as “forward guidance”, is neither set in stone nor can it be enforced in court, it is a signpost that gives investors security and creates confidence in the financial markets. But this time, the monetary authorities are not revealing their cards. At least not before they have broken through the three percent interest rate barrier.