The European Central Bank cut interest rates on Thursday for the first time in nearly five years, signalling a shift away from aggressive policies aimed at taming soaring inflation.
As inflation edged closer to the central bank's 2% target, the bank cut three key interest rates applicable to all 20 euro zone countries by 0.25 percentage points. The benchmark deposit rate was cut to 3.75% from 4%, the highest in the central bank's 26-year history, where it had been in place since September.
“The inflation outlook has improved significantly,” European Central Bank President Christine Lagarde said at a news conference in Frankfurt on Thursday. “It is now appropriate to ease the degree of tightening of monetary policy.”
However, the governor gave no clear indication of how many more rate cuts there will be or over how long it will take.
There is growing evidence around the world that policymakers believe high interest rates are effective at stifling economies and slowing inflation. Now they are lowering them, potentially providing some relief to businesses and households by making it cheaper to get credit.
On Wednesday, the Bank of Canada became the first G7 central bank to cut interest rates. The central banks of Switzerland and Sweden also recently cut interest rates.
In the United States, there has been reluctance to ease policy, with Federal Reserve officials waiting until they are more confident that recent stubborn inflation readings will end. The Bank of England has left the door open to cutting interest rates, with some officials saying a cut could come as soon as this summer.
Thursday's rate cut by the ECB, the first since September 2019, sent a strong signal that the worst of Europe's inflation crisis is certainly over. Average inflation across the euro zone peaked above 10% in the second half of 2022 as higher energy prices spread to consumer goods and services and workers demanded higher wages to ease the pain of higher prices.
The ECB has embarked on its most aggressive interest rate-hiking cycle in recent years, with policymakers raising the deposit rate that banks receive for depositing money overnight with the central bank to 4% in September from minus 0.5% in July 2022.
That helped euro zone inflation fall to 2.6% in May. Lower energy prices have helped lower inflation for much of the past year. Food inflation has slowed to less than 3% from more than 12% a year ago.
“Monetary policy has kept financing conditions restrictive,” Lagarde said, “and has contributed significantly to bringing inflation back down by keeping demand under control and inflation expectations well anchored.”
Europe's main stock indexes rose to record highs on Thursday before the rate cut announcement but gave up some of the gains amid signs that banks were becoming more cautious about future rate cuts.
The central bank warned that there are still strong signs of upward price pressures and that inflation will remain above its 2% target “well into next year.” Overall inflation is expected to average 2.2% next year, higher than the central bank's forecast three months ago.
Recent inflation data has been stronger than expected, especially sluggish services inflation, which accelerated to 4.1% in May from 3.7% the previous month. Policymakers are closely watching wage increases, which could boost consumer prices if companies pass on wage increases rather than absorbing them.
Lagarde said “wage growth has been high,” but is expected to moderate over the course of the year.
He added that he doesn't think central banks are yet in a “rate-cutting phase.” Rather, policymakers need to use new economic data to “always make sure we're on a disinflationary path” at each rate-setting meeting.
Traders are scaling back bets on further rate cuts this year, with cuts in September and December now about as likely as not.
“Central banks are in no rush to ease policy,” Mark Wall, Deutsche Bank's chief European economist, said in a statement.
Authorities face a tricky tightrope: On the one hand, policymakers want to cut rates in a timely manner to avoid damaging the economy too much and pushing inflation below target, and on the other hand, they don't want to ease policy too quickly for fear of rekindling inflationary pressures.
Investors are looking to the United States, where inflation is proving more robust than initially expected, and Europe, where they are wondering whether they should take what's happening now as a warning about what might come next.
There is also skepticism about how far the ECB can cut interest rates while the Fed waits.If interest rates rise in the U.S., the dollar's global role could keep financial conditions in the U.S. and elsewhere tight, risking a weaker euro and imported inflation.
After more than a year of economic stagnation, the region's economies are showing signs of recovery, further justifying the ECB's cautious stance. On Thursday, ECB staff projected euro zone economic growth to rise to 0.9% from 0.6% three months ago.
Lagarde said the services sector is expanding, the manufacturing sector is stable at a low level, and she expects exports to grow as global demand increases. At the same time, the combination of lower inflation and rising wages will improve consumer purchasing power. Lower interest rates will also make monetary policy less disruptive to the economy, she added.
Still, Ms. Lagarde stressed the uncertainty of the inflation outlook, saying inflation will likely fluctuate around current levels for the rest of the year and that “the road ahead will be bumpy.” Rate decisions will therefore be based on data available at each meeting.
“We are not committing in advance to a particular interest rate path,” she said.
