The ECB shouldn’t have cut interest rates

The European Central Bank (ECB) made a risky decision last month by cutting interest rates. Policymakers overlooked long-term inflation concerns and decided to act before having a full picture of the economy’s current state.

They met in Frankfurt on June 5th, discussing the uncertainties surrounding energy and food inflation and whether these prices would stabilize by 2026. The ECB said:

“At some point, it was necessary to make a judgment call based on the information available, even if that information was less conclusive than might be preferred.”

Despite these uncertainties, they went ahead and started reducing borrowing costs, aiming to hit their 2% inflation target. June saw the ECB begin to trim record-high borrowing costs as inflation nears the 2% target.

However, consumer price growth is expected to remain steady throughout 2024. Policymakers are cautious about cutting rates too quickly due to uncertainties like wage gains and political events, such as the upcoming French elections.

Investors expect one or two more reductions in the deposit rate by the end of the year, and several officials have shown support for this timeline.

Interest rates and economic risks

Policymakers made a controversial decision to cut interest rates by 25 basis points. The ECB stated:

“Such an approach should not be seen as conflicting with data-dependence, as waiting for full confirmation would almost certainly imply cutting interest rates too late, potentially creating a significant risk of undershooting the target.”

Even after the cut, interest rates remain in restrictive territory compared to the current estimates of the natural or neutral rate of interest.

They believed that reducing rates by 25 basis points would offer better protection against downside risks than maintaining the current levels.

“The concern was raised that, in the presence of both domestic political and geopolitical uncertainties, the saving ratio could go even higher than expected. If this were to happen, consumption could be curtailed for longer.”

ECB President Christine Lagarde noted that only one of the 26 council members, Austrian central bank governor Robert Holzmann, opposed the rate cut.

However, the ECB acknowledged that “some members” argued for keeping interest rates unchanged, citing surprising wage growth and stickier-than-expected inflation, mainly in the services sector.

Despite these reservations, there was a willingness to support the proposal. The reservations of some council members have raised investor expectations that the ECB will keep rates on hold when the council meets again in two weeks.

Markets are currently pricing in about two more quarter percentage point rate cuts this year.

Cryptopolitan reporting by Jai Hamid