ECB – Limited room for rate cuts

There is hardly any doubt that the ECB will cut interest rates for the first time at the beginning of June.

Dr. Marco Wagner

Commerzbank Economic Research

May 14 2024

This raises the question of how many interest rate cuts will follow and at what level the interest rate will end up in the long term. We analyse why the ECB will hardly be able to lower the deposit rate below 3%.

According to the interviews and comments of ECB Governing Council members, a first interest rate cut in June is a foregone conclusion. The Governor of the Banque de France, Francois Villeroy de Galhau, is looking further ahead: "... once the first rate cut has been decided, we will have two less frequently mentioned but more important choices, regarding the speed of the fall and the landing zone."

We assume that the ECB will cut its interest rates a total of four times, starting in June, quarterly at each meeting with new projections, by 25 basis points each time. This would probably correspond most closely to the current ideas of many ECB Governing Council members, who speak of "gradual" rate cuts. In addition, many Governing Council members believe that meetings at which new projections are presented are the best time to make monetary policy decisions. The main argument against a faster pace, i.e. more or larger steps, is probably – as explained by Lagarde at the press conference and now repeated by a number of ECB Governing Council members – that the path of inflation will be bumpy, at least for the remainder of this year. After the four interest rate cuts we forecast, a deposit rate of 3% would be reached in spring 2025. We see several reasons why the key interest rate is unlikely to fall significantly below this level in the foreseeable future:

#1: Special factors primarily driving the disinflation

An analysis by ECB experts suggests that core inflation in the eurozone since 2021 has been driven by global special factors, among other things, and that their phasing out since the summer of last year was mainly responsible for the fall in core inflation.In their study, Bańbura et al (2024) identify supply chain bottlenecks and energy shortages as special effects. On the other hand, core inflation adjusted for these special effects has been quite persistent in recent months. Taking the April figure into account, a very slight downward trend can be seen at best. The traditional drivers (labor market, supply and demand conditions) remain relatively unyielding. In view of the fact that the eurozone economy has avoided a recession, demand and investment are already picking up again and the labor markets are still working at full utilization, the traditional drivers of inflation are unlikely to lose their strength any time soon.

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