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The eurozone is poised for a much-needed economic boost on Thursday, when the European Central Bank is expected to begin cutting interest rates for the first time in nearly five years.
The extent of the boost will depend on how much further borrowing costs fall, but stubbornly high inflation fueled by rapid wage growth could limit the number of rate cuts, analysts say.
With markets taking the first rate cut for granted, investors will be intently looking to ECB President Christine Lagarde for clues on the future course of monetary policy.
By starting to cut rates again, the bank will breathe new life into housing markets, business investment and consumer spending. The ECB raised its key deposit rate to a record 4 percent last year, stifling economic activity to deal with the biggest rise in prices in a generation.
“Lower rates matter,” said Holger Schmieding, chief economist at Germany’s Berenberg bank. “Financial markets are well aware that this is coming, but news that the ECB has started to cut rates could draw [the] attention of households and businesses and lift sentiment.”
The eurozone economy showed preliminary signs of recovery already in the first three months of this year, with the bloc’s gross domestic product rising 0.3 percent from the previous quarter, ending a year of stagnation.
The growth spurt mostly reflected the fading of the energy and food price shock triggered by Russia’s large-scale invasion of Ukraine and the recovery in global trade, Schmieding said.
However, he said expectations of rate cuts also helped reduce the cost of mortgages and business loans. “This will lead to a bottoming out in the housing markets, a recovery in housing construction and should help restore investment as we expect this year.”
In Germany, house prices fell by 10 percent after the ECB started raising rates in 2022. But they are stabilizing this year after 10-year mortgage rates fell from nearly 4 percent last October to less than 3.2 percent, according to mortgage broker Dr Klein. .
“The more favorable interest rates have since led to a noticeable increase in demand for mortgage financing and the market has seen a significant upswing since then,” said Michael Neumann, head of private clients at Dr. Klein.
Marc van der Lee of the Dutch Association of Real Estate Agents predicted that house prices in the Netherlands will return to record highs in the second quarter, mainly due to rising wages and housing shortages, but also due to lower mortgage costs.
As for the next steps after Thursday’s meeting, the challenge for Lagarde is to break the steady decline in inflation from a peak above 10 percent in 2022. Data released last week showed that year-on-year price growth accelerated again to 2.6 percent in May from 2.4 percent a month earlier.
An unexpectedly strong eurozone labor market is also keeping price pressures high, with collective first-quarter wage growth rebounding to a record pace of 4.7 percent and unemployment in the bloc falling to a new low of 6.4 percent in April.
Most economists think the recent strong data means the ECB will need to slightly raise both its inflation forecast of 2.3 percent for this year and its GDP growth forecast of 0.6 percent.
Combined with signs that the Federal Reserve is unlikely to start cutting rates for several months – if at all this year – due to a strong US economy, investors have hedged their bets on less than a three-quarter cut by the ECB. year.
The timing of this week’s rate cut will be unusual for the ECB, which usually only initiates such monetary easing in response to a crisis, such as after the collapse of Lehman Brothers in 2008 or when Greece needed a series of bailouts in 2011.
Even the last rate cut by the ECB in September 2019 was a reaction to the weakening of growth and the drop in inflation below its two percent target.
“Rather than a worsening situation, they are interfering with an improving situation,” said Paul Hollingsworth, chief European economist at French bank BNP Paribas. “This means they will not rush to cut rates further, making another cut in July unlikely and leading them to only cut once a quarter.”
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Influential members of the ECB’s rate-setting Governing Council have already indicated they expect a gradual pace of easing, with only two more rate cuts likely this year.
The ECB’s chief economist, Philip Lane, told the Financial Times last month that rates were likely to “decline somewhat” over the course of the year while remaining in “containment territory”, which most economists expect to remain above 3%.
Dutch central bank chief Klaas Knot told an event in London last week that based on the ECB’s latest forecasts, its models showed that “optimal policy would be roughly in line with three to four rate cuts” by the end of the year.
For inflation to fall to the ECB’s two percent target by next summer, a combination of slowing wage growth, rising worker productivity and shrinking corporate profit margins is expected.
If those trends fail to materialize and inflation remains uncomfortably high, Hollingsworth said ratemakers “may have to stop after the first few cuts.”
Faced with such uncertainty about the economic outlook, Lagarde is widely expected to resist giving much indication of likely policy developments, allowing the bank to retain maximum flexibility in the extent of rate cuts for as long as possible.