ECB Expected to Cut Main Policy Rate in Significantly Momentous Move
The European Central Bank (ECB) is expected to make a major decision on Thursday by cutting its main policy rate. This move is highly significant as it will be the first time in 25 years since the single currency was introduced that interest rates have been this high. The expected rate cut will benefit millions of households and businesses across the eurozone, providing relief for those who have been facing high interest rates. Additionally, British tourists traveling to popular European summer destinations are also expected to benefit from the cut in rates, as the pound has already seen a 1.5% increase against the euro since mid-April.
Aside from the immediate impact on the economy, the ECB’s decision to cut rates will also have a larger significance in terms of central banks around the world. Earlier this year, it was widely believed that the US Federal Reserve would be the first major central bank to cut interest rates. This has been the trend since the Second World War, with the Fed typically cutting rates before its global counterparts. However, in 2011, there was a break in this tradition when the ECB cut rates in response to the eurozone sovereign debt crisis while the Fed kept its main policy rate unchanged. In 2013, the ECB began cutting rates again while the Fed remained unchanged, but this was during a time of economic turbulence.
Therefore, this week’s expected rate cut by the ECB will be the first time in relatively normal circumstances, prior to the Second World War, that the ECB (or the Bundesbank, the most important central bank in Europe before European monetary union) will cut rates before the Fed. It is important to note that the ECB is not the only central bank whose monetary policy is diverging from the Fed’s. The Swiss National Bank and the Riksbank, Sweden’s central bank, have already cut interest rates this year, and the Bank of Canada is also expected to cut rates later on Wednesday. In contrast, the Bank of England is expected to begin cutting rates in August while the Fed is not expected to do so until the final three months of the year.
Apart from breaking with the long-term trend, it is also worth noting that a rate cut from the ECB this week would be highly unusual as eurozone inflation is currently comfortably above the bank’s 2% target rate. This rate cut would be a response to concerns about weaknesses in the eurozone economy. However, diverging from the Federal Reserve’s monetary policy does not come without risks for the ECB. There are concerns about the impact on the exchange rate between the euro and the US dollar. A weaker euro would make exports from the eurozone to the US more competitive, but it could also lead to higher import costs, particularly for energy, which is priced in dollars. This could, in turn, push up inflation. Additionally, a weaker euro could also lead to risks in a US election year, where both candidates are likely to pursue protectionist policies.
Mohamed El-Erian, advisor to Allianz and Gramercy, and one of the world’s most experienced investors, recently wrote in the Financial Times: “Too large and persistent a divergence in rates risks weakening European currencies beyond the point where possible competitive advantages compensate for the costs of higher imported inflation. In a US election year, this could also fan protectionist tendencies that, already, are on the cusp of intensifying. The two together would risk financial instability that would spill back to amplify economic concerns.”
Due to these potential risks, most market-watchers do not expect this monetary policy divergence to continue for long. Bruce Kasman, head of global economic research at investment banking giant JP Morgan, stated in a recent webcast with clients: “The broad point is that if we look at 2024 [there are] limited opportunities for central bank easing – there is just not enough in terms of the inflation decline to actually argue that central banks can act aggressively. There is an opportunity for divergence but the broad message is that, in a world in which growth is overall resilient and inflation is still drifting lower but at a pace that’s not really getting you back… to something that central banks are quite comfortable with, it’s leaving you with relatively limited room for easing overall.”
This sentiment is shared by strategists at BlackRock, the world’s biggest asset manager, who told clients in a recent note: “Falling inflation and 18 months of weak economic activity make the case for the ECB to start cutting rates. But we don’t think it will cut far and fast. Likewise in the US, we see just one or two Fed cuts this year. This is not your typical rate cutting cycle. Investors may see opportunities in further policy divergence, but we think it will be temporary as both central banks ultimately keep rates high for longer.”
In summary, while the ECB’s rate cut will provide relief for households and businesses in the eurozone
