Why the ECB is having difficulty lowering interest rates

The European Central Bank is on the verge of its next rate cut after setting the stage for a new easing cycle in June. At its next meeting on Sept. 12, the ECB is expected to cut rates by another 25 basis points. With the U.S. Federal Reserve also signaling it would begin easing, the move should be easy for central bankers. But the European Central Bank's decisions will become much more contentious once rates fall to around 3% and arguments emerge over what is needed to keep inflation in check, people familiar with the matter told Bloomberg.

Interest rates: Finding the right balance

While the next two or three cuts in the deposit rate from its current level of 3.75% are unlikely to cause major disagreement among ECB members, the debate is likely to become more heated when it does, with differing views on both the price outlook and the point at which monetary policy stops dragging on economic growth leading to debate and conflict, said the people, who asked not to be identified.

Estimates for the latter point range from 2% to 3%. However, with inflation falling, markets and analysts expect rates to approach – or perhaps even reach – the upper end of that range by year-end, expecting them to eventually settle at around 2.5%.

There are initial signs of impending tensions.

“The closer interest rates come to the upper range of estimates of the neutral interest rate – that is, the more uncertain we are about how restrictive our policy is – the more cautious we should be to avoid monetary policy itself becoming a factor in curbing disinflation,” said Executive Board member Isabel Schnabel on Friday.

ECB: scope for interest rate cuts

ECB officials largely agree that there is still room for further rate cuts, as consumer price increases are still consistent with their forecast for a return to the 2% target by the end of next year.

After the first interest rate hike in June, further hikes are expected in September and December – to coincide with the publication of the quarterly economic forecasts. The markets are also not ruling out a further interest rate cut in October.

There is less agreement, however, on the extent to which inflation – which stood at 2.2% in August – is at risk of rising further. The ECB's dovish camp fears that the target will be missed, especially as the economy in the 20-country eurozone loses momentum. The hawks, on the other hand, fear that easing monetary policy too quickly could fuel inflation again.

Such arguments are already being expressed within the ranks of the 26-member ECB Governing Council.

Statements from ECB members

On the one hand, Greece's Yannis Stournaras has told central bankers to be “equally concerned about overshooting and undershooting the inflation target,” and Portugal's Mario Centeno said the ECB must “bring down inflation with the least possible sacrifice” – a reference to potential economic pain if monetary policy is too restrictive for too long.

He sees a risk of a return to the lower inflation and low growth environment that preceded the pandemic.

In contrast, Croatia's Boris Vujcic highlights continued price growth in the services sector, which rose to 4.2% in August, while Bundesbank President Joachim Nagel said last week that the ECB should not cut interest rates too quickly as “a somewhat stronger economic recovery could further delay the return to our target.”

The question of exactly when monetary policy begins to stimulate economic growth rather than slow it is even more controversial – especially because the so-called neutral interest rate is not observable and there are several estimates of its level.

In a January article, ECB economists said models suggest a real interest rate of between -0.75% and 1% — which implies a nominal rate of 1.25% to 3%. However, French economist Francois Villeroy de Galhau said in April that an estimate from the ECB and the French central bank suggests a nominal rate of 2% to 2.5%.

“This is not necessarily the target for the current phase of rate cutting,” he said at the time. “It just shows that we have considerable room to lower rates before we leave the restrictive zone.”

Cautious due to weaker economy

These rather dovish-sounding assessments of the neutral interest rate are based on the still weak fundamentals of the euro area economy – such as low birth rates and declining productivity. More hawkish monetary authorities take a different view and point to a range of 2.5% to 3%, which is driven by structural factors such as the costly transition to the green economy and the persistently tight labor markets.

“The ongoing risk of stagflation in the euro area will make rate cuts controversial beyond next week, as the ECB Governing Council is again significantly more divided between doves and hawks,” said Carsten Brzeski, head of macro at ING. “For the hawks to agree to a series of rate cuts, growth in the euro area must continue to weaken.”

FMW/Bloomberg

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