Interest rates down, the economy up?

The ECB is cutting interest rates – and has inflation largely under control. But there are still some challenges ahead.

They’ve done it again! For the fourth time this year, the members of the Governing Council of the European Central Bank (ECB) have lowered the key interest rate. Once again, the rate has been cut by 25 basis points, bringing the deposit rate down to 3.0 per cent.

However, according to François Villeroy de Galhau, Governor of the Banque de France, today’s rate cut is likely to be a temporary measure. For one thing, because victory over inflation in Europe is in sight. Moreover, he believes that the downside risks for growth and inflation have increased further. 

The risks have shifted

This sentiment is also reflected in the newly published December projections, which are prepared jointly by the staff of the Eurosystem and the ECB. The projections still do not paint a euphoric picture of the state of the eurozone economy. For the coming year, the staff anticipate modest growth of 1.1 per cent for the eurozone. This means that the growth estimate for 2025 has been revised slightly downwards in each of the last three projections.

The outlook for growth remains bleak. As a result, there is a growing perception that inflation rates will stabilise around the two per cent target over the coming year. According to ECB staff estimates, inflation will average 2.1 per cent in 2025. Core inflation is expected to average 2.3 per cent next year.

Overall, concerns about persistently (too) high inflation rates are therefore continuing to subside. Simultaneously, a possible undershooting of inflation is gradually taking on more weight in the ECB’s communication, as ECB Chief Economist Philip Lane recently emphasised: “Monetary policy should not remain too restrictive for too long. Otherwise, the economy will not grow sufficiently and inflation will, in my opinion, fall below target.”

The devil is in the detail

Without any noticeable change in the overall situation, the coming monetary policy path is roughly mapped out: additional interest-rate cuts are definitely on the cards. However, the ECB Governing Council continues to face a number of challenges in the current cycle of interest-rate cuts.

One cause for concern is the persistently high rate of inflation in the services sector, meaning that a significant part of the disinflation has yet to materialise. Service prices continued to rise sharply by 3.9 per cent in November. In this context, the focus remains on high wage growth, which accelerated to 5.4 per cent in the third quarter of 2024 – the highest rate since the eurozone was established. There are regional differences here. The latest ‘wage record’ was driven by an exceptionally strong 8.8 per cent increase in collectively agreed wages in Germany, which was mainly due to substantial one-off inflation compensation bonuses. Given that domestic inflation is still significant, it seems premature to give the all-clear for the (wage) upside risks of inflation. Nevertheless, the fact that recent wage adjustments in certain sectors are still lagging significantly behind the sharp rise in inflation experienced in the past provides some optimism. Furthermore, the latest wage negotiations for the metal and electrical industry in Germany, for example, are already showing a more moderate trend in wage growth. The pilot negotiation result of the IG Metall trade union, for example, provides for a 2.0 per cent increase in monthly wages from April 2025 and a further 3.1 per cent from April 2026.

Action and reaction

In addition to persistently high domestic inflation, the ECB is also facing another difficulty. After four interest-rate cuts, the question arises as to the pace and extent to which the degree of monetary policy restriction can be relaxed, given that inflation rates are still slightly above the inflation target of two per cent. Council member Isabel Schnabel is in favour of a very gradual approach. The focus here has recently been on the fact that monetary policy is approaching the ‘neutral area’ in which it has neither a stimulating nor a restrictive effect. In her assessment, Schnabel referred, among other things, to the latest survey on lending in the euro area. Almost all banks stated that the demand for credit is no longer influenced by the general interest-rate level. This is a major difference compared to last year, when almost half of the banks in the euro area stated that interest rates were having a negative impact on the demand for credit. Furthermore, an increase in demand for mortgages was also observed.

Naturally, it is not possible to say conclusively what the neutral level of interest rates should be. Schnabel personally would set it in a range between two and three per cent. But it is precisely this uncertainty that argues in favour of a cautious and gradual approach to possible future interest-rate cuts. Bundesbank President Joachim Nagel expressed a similar view, stating that an expansive monetary policy would only be justified if there were a significantly increased risk of the inflation target not being met.

The balancing act continues

High service prices suggest that the fight against excessive inflation in the eurozone is not yet fully over. At the same time, weak growth prospects and recent more moderate wage settlements suggest that the medium-term inflation risks in the eurozone are more on the downside. While a gloomy outlook argues in favour of a further softening of the degree of monetary policy restriction, the current inflation picture continues to suggest that a measured approach is still required.

The euro currency guardians are therefore likely to remain true to themselves in the new year and continue to act in a data-dependent manner. They have their sights firmly set on the neutral zone.

How did the markets react?

There was little movement in the bond markets immediately after the ECB meeting. Investors always pay very close attention to whether there are any changes in the wording used by central bankers.

And there were some deviations: from the earlier statement by the ECB [...] “The Governing Council is determined to ensure that inflation returns to its medium-term objective of two per cent in a timely manner. It will keep key interest rates at restrictive levels for as long as necessary [...]” the softer wording was used: [...] that inflation will stabilise sustainably at its medium-term objective of 2%. [...]”.

The market initially interpreted the change as meaning that the central bankers might be able to act somewhat more “dovishly”, i.e. they could take a more flexible approach to further easing monetary policy (and cut interest rates more than previously expected if the data environment allows).

This was followed by Christine Lagarde’s comment “that the neutral interest rate has not been discussed in recent days”. From a market perspective, this could indicate that a rethink of monetary policy – towards larger interest-rate adjustments (50 basis points instead of 25) – has become somewhat less likely in the foreseeable future. These tempered expectations of a somewhat more relaxed monetary policy again. As a result, yields rose slightly.

After the meeting (and after the described adjustments, first downwards and then upwards), yields on two-year and 10-year German Bunds were slightly above the previous day’s levels. At 1.75 per cent, the terminal key interest rate expected in the future seems “ambitious” in any case.

(Foto: Unsplash)