If what goes up must come down, then the urgent question on the minds of many in Europe is when will interest rates begin dropping? For months, rates have been set at the highest in the European Central Bank’s history.
Investors have been betting that the central bank will cut rates quite soon — possibly in April. Traders figure rates must come down because inflation has slowed notably — it’s been below 3 percent since October — and the region’s economy is weak. By the end of year, the central bank will have cut rates by more than one percentage point, or between five and six quarter-point cuts, trading in financial markets implied.
Policymakers, however, are trying to pull market opinion in the other direction and delay the expectations of rate cuts. Many of the central bank’s Governing Council are wary of declaring victory over inflation too soon, lest it settle above the bank’s target of 2 percent.
On Thursday, the European Central Bank stuck to this outlook. It held interest rates steady, leaving the deposit rate at 4 percent, where it has been since September.
Rates are at levels that, “maintained for a sufficiently long duration, will make a substantial contribution” toward returning inflation to 2 percent in a “timely manner,” Christine Lagarde, the president of the bank, said on Thursday.
The region needs to be “further along” in the disinflation process before the bank can be confident that inflation will stay at target, she added.
Not now, but probably in the summer
There has been a shift at the central bank recently. In December, Ms. Lagarde said rate cuts hadn’t been discussed and emphasized the need to be vigilant against inflation. But the new year brought a slight change of tune. And last week, Ms. Lagarde said in an interview with Bloomberg News that it was likely that rates could come down in the summer.
Asked about this again at a news conference in Frankfurt on Thursday, Ms. Lagarde said the 26-member Governing Council still agreed that it was “premature to discuss rate cuts.” Policymakers would make their decisions based on incoming economic data, not by following a calendar, she said, seemingly in an effort to keep bets on rate cuts at bay.
Still, she said, “I typically stand by my comments.”
It’s a comment traders have seized on, and they are now firmly expecting a rate cut at the bank’s June meeting, while bets for April have increased.
Central banks have to choose their words carefully to guide markets because it matters what investors think. If traders begin to anticipate lower interest rates, they can move the markets in that direction and ease financial conditions sooner than the central bank would like. That could potentially undermine efforts to restrain the economy and slow inflation. This started to happen in earnest late last year, after the Federal Reserve signaled it would cut rates this year, which caused markets to move in the United States and internationally.
Delaying expectations
Policymakers have tried to delay expectations of rate cuts until at least the summer, arguing they won’t have the data they need, particularly on wage growth, until their meeting in June.
“The E.C.B. will err on the side of caution,” said Oliver Rakau, chief German economist at Oxford Economics, because it is nervous about being wrong again on inflation, after previously underestimating its strength.
Meanwhile, those who say inflation will keep slowing are relying on the economy’s not enduring any more major shocks. Attacks on commercial ships in the Red Sea have caused shipping prices to spike, and analysts are warning of a possible resurgence in inflation if the disruption goes on for a long time and those cost increases are passed to consumers.
Sooner rather than later?
On the other hand, data shows inflation has been easing faster than the central bank predicted. Headline inflation ticked up in December as some government support measures ended, but could fall below 2 percent by the autumn, according to economists at Berenberg Bank.
The region’s economy is also weak, not overheating. Germany’s economy, the largest in the bloc, is sluggish, after data showed it contracted 0.3 percent last year. Separate data published this week showed that demand for loans from businesses and households across the eurozone was continuing to decline.
But it’s possible to look at this situation somewhat positively, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “It could have been much, much worse,” he said. For example, the recession in Germany could have been significantly deeper, he added. “Inflation was a disaster,” he said. “It’s not under control but is going in the right direction.”
He expects the central bank to start lowering rates in June and cut them by a full percentage point in aggregate by the end of the year. Other economists, including those at Goldman Sachs and Deutsche Bank, predict rate cuts to begin in April.
While there is a debate over how soon and how fast rates will go down, most economists agree that the ultralow rates are a thing of the past.
“The very low rates we had seen prepandemic are unlikely to return, said Mr. Rakau of Oxford Economics, because there is a much greater need to borrow money to invest, particularly in renewable energy and new technologies.
