That’s it for the easy part. The European Central Bank (ECB) committed a few weeks ago to lower interest rates in June in the face of the powerful disinflation that has been witnessed in the eurozone and will do so next week. But this rate drop will be like a mirage or ‘trap’ that will put ‘honey on the lips’ of those who expect strong financial relief. After this movement, the ECB faces a dizzying abyss. Disinflation has been rapid and powerful, but it has stalled much sooner than the ECB would have wanted, and confirms the mantra that the last effort to reach the 2% target is the hardest. To make matters worse, salaries have risen strongly again in the latest data published and the euro zone economy seems to wake up driven by consumption and investment. What is on the horizon beyond June? The members of the ECB are clear: “Maximum uncertainty.”
With the CPI of the euro zone at 2.6% (and with the risk of rebounding in the coming months), the ECB will have to decide if the June rate cut is the beginning of a cycle of cuts in the price of money or if everything simply remains a gesture that shows that when the ECB He says something he does it (the credibility of a central bank is one of the most important factors in ensuring price stability). The truth is that the strength of wages and inflation have overturned market expectations of rate cuts in a matter of a few months. Of the eight cuts that were ‘predicted’ in 2024, now the market only sees two: one in June and another that could arrive during the rest of the year.
A few months ago, the Governing Council of the ECB was clear about this. The CPI had moderated strongly. In about a year and a half, inflation has moderated by more than seven points. But in the fight against inflation there is no easy victory. When everything seemed won, the euro zone economy has begun to rebound, the labor market continues to create employment amid the shortage of workers and salaries have risen by 4.7%, in the first quarter of 2024, one of the highest rates in the last 30 years. Salaries in Germany increased by 6.4% in nominal terms and 3.8% in real terms, the largest increase in the entire historical series. All these factors have caught the ECB on the wrong foot. When the central bank and the markets indicated several rate cuts, the ‘monster’ of inflation has woken up from its KO.
The ECB faces an unprecedented and at least curious situation. All the indicators that should define the central bank’s monetary policy offer signs that inflation will remain high: low unemployment, salary strength, an economy that is beginning to rebound, oil that continues to decline… However, what the ECB is going to do is announce a rate cut. Interest rates have probably never been lowered before in an economy that shows so many symptoms of ‘overheating’.
“As the long-awaited first ECB cut in June approached, the debate on monetary policy in the euro zone has been changing rapidly. The caution of ECB hawks about cuts is fundamentally based on two indicators: inflation domestic service sector (which is the stickiest) and still strong wage growth in the first quarter, as reflected by the ECB’s negotiated wage growth indicator, which rose again last week to 4.7% year-on-year”, they explain from TS Lombard. An extreme strength in wages, although it may seem contradictory, is a great concern for any central bank, especially when productivity does not keep pace. This trend can entrench inflation and end up generating a price-salary spiral..
As RBC experts point out: cutting in the middle of an economic recovery is dangerous. However, these economists believe that the ECB will continue to lower rates in 2024, although at a lower rate than expected by the market, which even predicted 8 rate cuts this year. “The recovery in activity in the euro area appears to be occurring faster than expected and growth appears to have returned to a near trend pace. After large downward surprises at the end of 2023, recent data has shown signs of more persistent underlying inflation, and services inflation, in particular, has been rigid… In this context, it is likely that The ECB acts cautiously after setting a first interest rate in June“. These experts believe that interest rates will become chronic at 3%.
From eight cuts in 2024, to only two
Although expectations of rate cuts in 2024 have not been completely erased in the euro zone, the reductions that were expected at the beginning of the year are not going to happen. In December 2023, the market even discounted up to 8 rate cuts by the central bank, a scenario that was diluted as the months went by until leaving the outlook at only two cuts before the end of the year. Furthermore, the ECB has been very careful in recent months to try to convince the markets of the importance of being flexible in their expectations, since the environment is uncertain, and it seems that it will continue to be so in the coming months.
To this end, the agency made it very clear that it is following a “data-dependent” approach. As the most important indicators for the organization are updated, the roadmap will be rethought, somewhat that forces the ECB to move in a delicate balancewithout getting his fingers caught, but trying to anticipate the markets’ next movements, as he usually does, and thus try to avoid sudden movements in the financial markets.
This position of the ECB makes the meetings in which the organization updates its macroeconomic forecast table become increasingly important, as will happen, for example, in next week’s meeting. Later, it will do so at the September meeting, and again in December, to close the year. The members of the Governing Council of the organization will have available next Wednesday the table of expectations prepared by the team of ECB economists, and will decide, with these figures on the table, whether to lower rates, and what they communicate to the public regarding the next months.
Some important members of the central bank, such as the case of Philip Lane, chief economist of the organization, warn that interest rates must remain in restrictive territory for a time. “The best way to frame the debate this year is that we have to be restrictive throughout the year,” Lane said in an interview published last Monday. This, however, does not erase the possibility that there could be some rate cut in the coming months: “Within the restrictive policy zone, we can afford to lower rates somewhat,” he said, referring to the week’s meeting. coming.
However, it seems that there is only room for a rate cut after what may arrive in June, but it is a scenario that cannot be taken for granted, far from it, taking into account the upward surprises that inflation is giving at specific times this year, both in the United States and in the euro zone.
Inflation accelerates
The most recent inflation data justify the ECB to redouble its caution and have more doubts about how to act after June. The May CPI in the euro zone, released this Friday, rose two tenths to 2.6% year-on-year. But beyond this figure, the message left by the rest of the data is that the last kilometer of disinflation is going to be hard for the ECB.
The best proof of this is the underlying inflation data (excluding energy, food, alcohol and tobacco). In the preliminary reading for May published by Eurostat, the index climbed two tenths to 2.9%, getting dangerously close to 3% and moving away from the desired target of 2%. The main culprit was once again a services sector that has become the main headache for ECB officials. The services CPI rose last month from 3.7% to 4.1%, the highest reading in seven months. Excluding the April data, softer because the comparison was made between an April without Easter (this year) and another with it (last year), the metric has remained above 4% since September 2022, which gives a magnitude of the problem.
The truth is that the indicator does not weaken in the main economies of the region. In Germany the services CPI continues above 3.5% and in France ING analysts expect it to not fall much below 3% (it was 2.7% in May). This will contribute to underlying inflation remaining stuck at 2.7%, as analysts predict, in May. A level that is still very far from the 2% that the ECB wants to see and that may even get close to 3% again, the Commerzbank research service warns.
“Services inflation remains well above 2019 levels in most major economies, and services inflation in developed markets has stagnated around the same rate in recent quarters. Overall , it is likely that services inflation will remain rigid and that central banks will be cautious when contemplating their relaxation cycles,” Citi states.
In the German case, which extends to the entire region, Commerzbank experts point out that it is key to elucidate to what extent companies will be able to pass on the higher salary costs to their clients: “The recent, somewhat stronger short-term impulse in commodity prices services shows that companies managed to do so in part, at least so far. We assume that this will also be the case in the coming months and that, therefore, the underlying inflation rate will stabilize around 3%.
The ‘heat’ of services
This ‘flame’ of services lights the fire that burns the fingertips of the members of the ECB the most, what is known as domestic inflation, a price measure that reduces the intensity of imports and that offers a better x-ray of what is happening in the region given its relationship with services and employment. “Domestic inflation, which the ECB is heavily focused on, fell to 4.32% year-on-year in April from 4.42% in March. However, momentum remains strong and increased in April, the seasonally adjusted annualized quarterly rate now stands at 5.32%“, Danske Bank analysts warned after the April CPI. As explained by Société Générale, the high wage growth and low productivity that are occurring in the eurozone constitute a significant upward risk for this inflation measure.
All these doubts made Isabel Schnabel, member of the Executive Committee of the ECB (the body that has the most weight in the decision-making of the central bank), left the doors quite closed to a second rate cut by the ECB in July in an interview a few days ago: “Recent data have confirmed that the last stretch of disinflation is the most difficult. The disinflation process has slowed down… and is turning out to be quite bumpy, and this seems to be a global phenomenon,” admitted the German economist, who has been criticized by some European financial media. pointed out as the ‘baton’ among officials in recent months.
“After so many years of very high inflation and with inflation risks still tilted upwards, an early concentration of the flexibility process would entail the risk of premature flexibility. Greater progress is needed in inflation and especially in domestic inflation, which is becoming more difficult, for build our confidence that inflation will sustainably return to our 2% target no later than 2025,” added the German.
