ECB Expected to Cut Interest Rates at June 6 Meeting

Anticipated Rate Cuts

At its upcoming meeting on June 6, we expect the European Central Bank (ECB) to announce a 25 basis point reduction in key interest rates. The new rates will be:

  • Main refinancing rate: 4.25%

  • Marginal lending rate: 4.50%

  • Deposit rate: 3.75%

These adjustments mark the first rate cuts for the main refinancing and marginal lending rates since March 2016, as well as the first cut for the deposit rate since September 2019.

Rationale Behind the Rate Cut

The ECB's decision to cut rates follows a significant reduction in the eurozone's headline inflation rate, which fell from a peak of 10.6% in October 2022 to 2.6% in May 2024. A cumulative 450 basis point increase in interest rates between July 2022 and September 2023 is responsible for this decrease. ECB President Christine Lagarde had previously indicated that sufficient data would be available by June to justify such a move.

While inflation has not yet reached the ECB's 2% target, the trend suggests a continued decline. The latest ECB projections indicate an average inflation rate of 2% in 2025 and 1.9% in 2026, with core inflation projected at 2.1% for 2025 and 2.0% for 2026.

Economic Context

The eurozone's economic growth has been sluggish, with a 0.3% expansion in Q1 2024 following contractions in the two preceding quarters. The elevated borrowing costs have contributed to this slowdown by containing demand and putting a brake on price pressures.

Future Rate Cuts and Economic Projections

There is no pre-commitment to future rate cuts despite the widespread expectation of a cut in June. The ECB aims to retain flexibility, with more data-driven decisions anticipated in July and September. Market expectations currently predict two to three rate cuts by the end of 2024, totalling 60 basis points.

The ECB's new economic projections may suggest slight upward adjustments in growth and inflation for 2024 while maintaining the 2% inflation forecast for 2025.

Risks of Rate Adjustments

The ECB must balance the risks of cutting rates too much or too little:

  • Excessive Easing: While rapid and significant easing could boost consumer demand and investment, it also carries the risk of reigniting inflation before achieving the 2% target. It also reduces the ECB's buffer against uncertainties like energy price volatility and geopolitical tensions.

  • Insufficient Easing: For too long, maintaining a restrictive monetary policy could stifle economic growth and widen the economic gap with the United States.

The ECB is likely to take a middle-ground approach, cutting rates in June while adopting a data-dependent strategy for future decisions.

Impact on Exchange Rates and Financial Markets

The divergence between ECB and Federal Reserve policies could significantly impact exchange rates. Aggressive ECB rate cuts, while the Fed maintains higher rates, could pressure the euro against the dollar, potentially increasing the cost of imported goods and services. Conversely, a cautious approach by the ECB may help stabilise exchange rates but could prolong economic sluggishness.

Conclusion

The ECB's anticipated rate cut on June 6 reflects its efforts to support economic growth while managing inflation. By adopting a cautious, data-driven approach to future rate adjustments, the ECB aims to navigate the complex economic landscape and maintain stability within the eurozone.

Defoes