ECB cuts interest rates – will the Bank of England follow suit?

The European Central Bank has cut interest rates for the first time in five years, with the policy rate in the euro zone falling by 25 basis points to 3.75 percent.

However, the bank also upgraded its expectations for eurozone inflation over the next 18 months and warned that it will keep interest rates restrictive ‘as long as necessary’.

The ECB is the second G7 country to continue with policy easing after the Royal Bank of Canada cut its policy rate by 25 basis points (bps) to 4.75 percent on Wednesday.

Economists and investors now expect the Bank of England to follow suit, while analysts are divided over a key rate cut in the summer.

Markets had been pricing in the ECB’s first cut for some time, with the central bank signaling the direction of policy in recent months as inflation eased and the bloc’s economy showed signs of faltering.

The ECB said: ‘Given the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restraint after nine months of stable interest rates.’

But investors looked to the ECB’s commentary as a guide to the path ahead and were faced with a conservative outlook.

Despite progress on inflation, the ECB admitted that “domestic price pressures remain strong as wage growth is high, and inflation is likely to remain above target well into the year.”

The Eurosystem staff projections for both headline and core inflation have been revised upwards for 2024 and 2025 compared to March forecasts.

The ECB now expects headline inflation to average 2.5 percent in 2024 and 2.2 percent in 2025, before falling below the 2 percent target from 1.9 percent in 2026.

The bank said: “The government is committed to ensuring that inflation returns to the medium-term target of 2 percent in a timely manner.

“It will keep policy rates sufficiently restrictive for as long as necessary to achieve this goal.

‘The Board will continue to take a data-dependent approach on a meeting-by-meeting basis to determine the appropriate level and duration of restriction.

‘In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission.’

The ECB knows it has to be cautious as inflation in the eurozone rose from 2.4 to 2.6 percent in May, while core inflation also rose 20 basis points to 2.9 percent.

The bank will also be keen to avoid decoupling monetary policy too far from that of the US Federal Reserve, whose first rate cut is now not expected until much later this year, amid persistent inflation and surprisingly resilient economic performance in some areas. such as in the field of the labor market. market.

There are concerns that too far of a US policy decoupling would lead to further pressure on the euro, which could be both reflationary and damaging to growth. Likewise, the Bank of England will want to avoid similar problems for sterling in the coming months.

Simon French, chief economist at Panmure Gordon, said: ‘Central banks are aware that with persistent core inflation in the US, partly fueled by stronger demand conditions than in the rest of the developed world, the exchange rate is having an impact on imported inflation through a worsening of inflation. in the US dollar, the terms of trade is a material risk factor.

‘It is notable that the Swedish krona, the Swiss franc and the Canadian dollar (where interest rate cuts have started) have weakened significantly since the start of the year than the British pound and the euro.

‘However, it should also be noted that both the krona and the franc have now reached their USD values ​​compared to the day of the rate cut. This recovery will not go unnoticed in Frankfurt and London as they consider their own policy steps.”

Market prices show that the ECB will cut interest rates twice more before the end of the year, bringing the policy rate to 3.25 percent.

When will the BoE cut?

Expectations for the timing of the Bank of England’s first rate cut have changed dramatically this year as new economic data continued to influence market opinion.

Not long ago, market prices suggested that the BoE would join the ECB on a rate cut in June, but it is now believed that the UK central bank will cite still high core inflation and the impending general election as reasons for delaying until August.

UK consumer price index inflation rose 2.3 percent more than expected in the 12 months to April, but fell from 3.2 percent the month before as the core CPI remained frustratingly stable at 3.9 percent .

But construction sector data released Thursday could offer some optimism to the Monetary Policy Committee when it meets on June 20.

Thomas Pugh, economist at RSM UK, said: ‘The key news for the MPC was that the PMI input price index for the construction sector fell to 50.4, well below the five-year average of 66.2.

‘The conclusion from this is that April’s persistent inflation figures were likely a direct response to the minimum wage increase, rather than a reflection of underlying price pressures. Price pressure is now decreasing throughout the economy.’

Market prices show that the BoE can make only two interest rate cuts of 25 basis points each this year, bringing the base rate from the current level of 5.25 percent to 4.75 percent.

However, analysts at UBS are more optimistic and expect a 75 basis point rate cut from the BoE this year – bringing the base rate to 4.5 percent at the end of 2024 – followed by 175 basis points in 2025.

UBS said: ‘However, in light of the disappointing inflation data, we recognize the risk of a later cut in August.

‘Markets are currently pricing in a 1 basis point rate cut by June, 9.5 basis points in August, while the first rate will not be priced in until November.’