Market Analysis

The European Central Bank (ECB) is poised to cut interest rates from their record highs on Thursday, recognizing progress in its battle against high inflation, yet emphasizing that the fight is far from over due to persistent price pressures in the services sector.

ECB officials have indicated their intention to lower borrowing costs after observing a drop in inflation across the 20 eurozone countries, from over 10% in late 2022 to just above their 2% target recently.

This significant decline is considered sufficient for the ECB to start reversing its unprecedented series of interest rate hikes, which were implemented in response to surging prices following Russia's invasion of Ukraine.

The ECB will now follow the central banks of Canada, Sweden, and Switzerland in cutting rates, positioning itself ahead of the influential U.S. Federal Reserve.

However, what initially seemed like the onset of a major easing cycle now appears uncertain, as signs indicate that inflation might be more persistent in the euro area than expected, similar to the situation in the United States.

As a result, ECB President Christine Lagarde and her colleagues are unlikely to commit to further rate cuts at their July meeting or beyond. Instead, they are expected to emphasize that any additional moves will depend on incoming data and that borrowing costs must remain high enough to control inflation.

"Further cuts in September and December remain our central case," HSBC economist Fabio Balboni noted. "But if the recent resilience in services inflation persists, we see increasing chances that the ECB might need to be more cautious."

All 82 economists polled by Reuters expect the ECB to reduce its deposit rate to 3.75% on Thursday from a record 4.0%, marking its first cut since 2019.

Not everyone agrees this is the right move. Gabriele Foà, a portfolio manager at Algebris Investments, suggested the cut "may soon be viewed as a policy mistake," while JPMorgan economist Greg Fuzesi described it as "oddly rushed."

"If economic data didn't support a rate cut back in March, they support it even less today," said Lorenzo Codogno of LC Macro Advisors. "Inflation hasn't declined as the ECB expected, indices linked to domestic demand have increased, wage growth has risen, and overall demand and GDP growth have strengthened.”

ECB chief economist Philip Lane recently stated that a rate cut would not signify "victory," and the pace of further reductions would depend on domestic inflation and demand progress.

Most economists still anticipate two more rate cuts by year-end, but markets are only pricing in one to two additional moves, a significant shift from early in the year when over five cuts were expected in 2024.

However, stronger-than-expected data in recent weeks have raised concerns about a tougher-than-anticipated "last mile" to achieving 2% inflation, a worry often voiced by influential board member Isabel Schnabel.

Eurozone inflation rose more than expected in May, with services sector price growth, a key indicator of domestic demand, rebounding to 4.1% from 3.7%, according to preliminary estimates.

This likely reflects larger-than-expected wage increases in the first quarter, which boosted consumers' disposable income following years of below-inflation pay raises.

A critical factor might be the Federal Reserve, which has clearly signaled a delay to its own easing cycle, influencing a more cautious approach in Frankfurt.

"The pace of rate cuts will depend on the U.S. and the Fed," said Mohit Kumar, an economist at Jefferies. "If the Fed doesn’t cut rates this year - not our base case - we could see only two cuts from the ECB this year."

A rebound in growth has also reduced the urgency for the ECB, likely leading to some upward revisions in growth forecasts on Thursday, undermining the argument that high rates are stifling economic activity.

Nevertheless, new forecasts are expected to show inflation returning to the ECB's 2% target next year, keeping the central bank on course for more easing unless new inflation surprises arise.

"Given the five quarters of stagnation in the eurozone economy from autumn 2022 to the end of 2023, the ECB may have overreacted with its rate hikes," said Holger Schmieding, an economist at Berenberg. "From this perspective, somewhat lower rates make sense."

Paraphrasing text from "Reuters" all rights reserved by the original author.