ECB: Lower Cruising Altitude

The European Central Bank (ECB) cut policy rates by 25 basis points at its June meeting, its first rate cut in almost five years, but did not provide firm guidance on how its rate cycle may proceed from here. While the ECB Governing Council (GC) has lowered its cruising altitude somewhat, the data flow over the coming months will decide the speed at which the ECB removes additional restrictiveness. In the meantime, we expect policy will remain tight and decisions taken on a meeting-by-meeting basis, with the ECB unlikely to precommit to a particular rate path.

In line with June’s first step in the cutting cycle, which takes the deposit rate to 3.75%, we believe the ECB will continue to proceed cautiously in conventional 25-basis-point moves. Given the ECB’s reaction function (which is based on the inflation outlook, underlying inflation dynamics, and policy transmission), we envision the ECB will keep cutting rates at staff projection meetings, with non-projection meetings less likely to see policy changes. September provides the next opportunity to holistically reassess the disinflation process, and the final staff projection meeting of 2024 takes place in December.

The market is currently pricing another 35 basis points of ECB rate cuts this year, and a policy rate of 2.8% at the end of 2025. The terminal rate priced at around 2.5% – well above most estimates for a neutral policy rate for the euro area – speaks to elevated “last mile” inflation concerns among investors. Contrary to earlier this year, this pricing now seems reasonable and is broadly in line with our long-held baseline of three cuts for 2024, with one cut at each of the two remaining staff projection meetings.

Risks are skewed towards fewer cuts, mainly on the back of sticky services inflation, a resilient labour market, loose financial conditions, and ECB risk management considerations. The spotlight during the second half of the year will likely remain on wage developments and services inflation, particularly in light of a record low unemployment rate of 6.4% and still elevated job vacancies.