Overview
What happened
The ECB as expected left policy rates unchanged at its April meeting, but the Governing Council’s updated policy statement clearly indicates a desire to start cutting rates at its next meeting in June. In particular, a new paragraph in the statement makes clear that it would be appropriate to reduce rates if the council’s three tests for assessing whether inflation is converging back to target, are met. This enhanced forward guidance and an assessment that the Council is gaining further confidence that inflation is converging to target, despite recent services inflation prints surprising slightly to the upside, sends a clear dovish signal.
At the press conference, President Lagarde sought to strike a more balanced tone. She highlighted that growth risks remained tilted to the downside, and labour market tightness was declining. She also noted that credit dynamics remained weak, especially for businesses, a message that is showing up in the latest bank lending surveys and that also seems to be mirrored in real loan activity. These factors, combined with profits and wages growing less strongly than anticipated, clearly give the Governing Council greater confidence that it can move toward an easing of policy.
Nevertheless, President Lagarde didn’t entirely remove the ECB’s message that it is dependent on what ongoing data releases show. June releases on profits and wages, as well as updated staff projections, will be the critical final inputs in the Council’s decision making at the next meeting.
Our interpretation
While Lagarde and the policy statement continue to emphasise dependence on upcoming data, this is effectively now a fig leaf covering what is clearly a pre-announcement of a June cut.
The President told the post-meeting press conference that “a few” Council members were in fact already of the view that they should begin cutting now, and when specifically asked about the slowness of services disinflation, President Lagarde was clear that the ECB will not wait for all categories to get back to 2 per cent. This is an important and clever clarification in our view. Unlike Fed Chair Jerome Powell, who has found himself in a twist by focusing on specific categories, President Lagarde and the ECB have been consistent in emphasising a broader range of measures of underlying inflation. Looking at these statistical measures, it becomes clear why the bank is gaining more confidence that inflation is heading back to target, with many of these measures at or quickly moving towards 2 per cent.
Our outlook
Activity in the euro area is moving slowly to a marginally stronger footing, but we agree with President Lagarde that risks to growth remain skewed to the downside. The latest euro area bank lending survey demonstrates this clearly, with demand for business loans now falling at an accelerated pace versus the previous quarter. Additionally, real wages in the euro area remain significantly below their pre-pandemic level and external sources of growth, including the Chinese economy, remain weak.
At the same time, more timely measures of wages from Indeed (a further component of the ECB’s assessment of the underlying inflation process), and the ECB’s own real-time tracking, suggest wage growth has definitively turned the corner, and is now falling back towards levels consistent with the Bank’s inflation target. We would expect this process to continue to June, by when the ECB will have the latest available data on margins, which should also show some contraction.
So the intention to begin cutting in June has now effectively been communicated by the ECB, and data by then is likely to enable this. What happens after that will continue to depend on the Fed. While President Lagarde sought to make a clear delineation between the evolution of US data (in so far as it impacts euro area data), as opposed to policy rates, we believe this is splitting hairs, particularly in the context of US inflation prints that have continued to surprise to the upside and look increasingly likely to constrain the Fed into just one or even no cuts this year.
The bank seems set to cut in June, but we believe that the path beyond this starting point will depend on the rate path of the Fed. President Lagarde stressed in her comments after the April decision that there is a clear delineation between the evolution of US data, as opposed to policy rates. Yet US inflation prints have continued to surprise to the upside and it looks increasingly likely this may constrain the Fed into just one or even no cuts this year.
With the dollar already strong, a sharp divergence in policy rates between the euro area and the United States clearly has implications for currency markets and the value of the euro, and in turn for the cost of commodities and other goods. As a result, while we continue to believe that the ECB will be the first central bank to start cutting rates this year, the path beyond that will almost certainly remain dictated by Fed action.
