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The euro zone is set to get a much-needed economic boost on Thursday as the European Central Bank is expected to start cutting interest rates for the first time in almost five years.
Analysts say the size of the cut will depend on how much borrowing costs fall in the future, but that high inflation due to rapid wage growth could limit the number of cuts.
With markets expecting a first rate cut, investors will be eagerly awaiting clues from European Central Bank (ECB) President Christine Lagarde about the future direction of monetary policy.
By cutting rates again, the ECB would inject new energy into the housing market, business investment and consumer spending.The ECB raised its base deposit rate to a record 4% last year and has been reining in economic activity to combat the biggest inflation surge in a generation.
“Lower interest rates are important,” said Holger Schmieding, chief economist at German bank Berenberg. “Financial markets are well aware that lower interest rates are coming, but the news that the ECB has started to cut rates is a bit of a shock.” [the] It attracts attention and emotion from households and businesses.”
The euro zone economy has already shown signs of recovery in the first three months of the year, with the region's gross domestic product rising 0.3% from the previous quarter, ending a year of stagnation.
Schmieding said the rapid growth mainly reflected the subsidence of the energy and food price shock caused by Russia's full-scale invasion of Ukraine and a recovery in global trade.
But he said hopes of lower interest rates had also helped make mortgage and business loans more costly. “This should help the housing market bottom out, lead to a recovery in homebuilding and help investment pick up as we expect it to this year.”
In Germany, house prices have fallen 10% since the ECB began raising interest rates in 2022. But mortgage broker Dr Klein said prices have stabilised this year as 10-year mortgage rates have fallen to less than 3.2% from almost 4% last October.
“Since then, favourable interest rates have significantly increased demand for mortgages and the market has experienced a significant recovery since then,” said Michael Newman, head of private clients at Dr Klein.
Mark van der Lee of the Dutch Association of Estate Agents predicted Dutch house prices would bounce back to record highs in the second quarter, mainly reflecting rising wages, a housing shortage and falling mortgage costs.
The issue for Lagarde in terms of further movement after Thursday's meeting is that it has interrupted a steady decline in inflation that peaked above 10% in 2022. Data released last week showed annual price growth accelerated again to 2.6% in May, from 2.4% the previous month.
The euro zone's unexpectedly strong labor market is also keeping inflationary pressures high, helping to push euro zone-wide wage growth to a record 4.7 percent in the first quarter and helping to push the euro zone's unemployment rate to a record low of 6.4 percent in April.
Most economists believe the recent strong data means the ECB will have to slightly raise both its inflation forecast of 2.3% and its GDP growth forecast of 0.6% this year.
Combined with signs that the strength of the U.S. economy makes it unlikely that the Federal Reserve will start cutting interest rates in the coming months or even this year, investors expect the ECB to limit interest rates to fewer than three quarter-point cuts this year.
The timing of this week's rate cut will be unusual for the ECB, as it has typically only eased monetary policy in response to crises, such as after the collapse of Lehman Brothers in 2008 and when Greece needed a series of bailouts in 2011.
The ECB's last rate cut, in September 2019, was also in response to slowing growth and inflation falling below its 2% target.
“They're cutting into an improving situation, not a worsening one,” said Paul Hollingsworth, chief European economist at French bank BNP Paribas. “That means they're in no rush to cut rates further, making another cut in July unlikely and leaning towards just one cut a quarter.”
Key members of the ECB's governing council have already signalled they expect the pace of easing to be gradual, with only two more rate cuts this year.
ECB chief economist Philip Lane told the Financial Times last month that interest rates would “fall some” this year but would likely remain in “tightening territory,” and most economists expect them to remain above 3%.
Dutch central bank Governor Klaas Knot said at an event in London last week that based on the ECB's latest forecasts, models showed that “the optimal policy would have been roughly three to four rate cuts” by the end of the year.
The ECB believes a combination of slower wage growth, higher worker productivity and narrower corporate profit margins is needed to bring inflation down to its 2% target by next summer.
If those trends don't materialize and inflation remains uncomfortably high, Hollingsworth said, rate-setters “may be forced to pause after the first few rate cuts.”
Faced with such uncertainty about the economic outlook, Lagarde is widely expected to resist giving too many indications about the direction of policy, allowing the bank to maintain maximum flexibility on the size of rate cuts for as long as possible.
