Interest rate decision: Is the ECB making a mistake and cutting interest rates too early?

This article is adapted from the business magazine Capital and is available here for ten days. Afterwards it will only be available to read at www.capital.de. Like stern, Capital belongs to RTL Deutschland.

The clock in Frankfurt had already advanced to 3:30 p.m. on this Thursday afternoon when a Spanish journalist asked President Christine Lagarde the last question at the ECB press conference: How much of a deviation in inflation rates the central bank was willing to accept and still say that she had reached her goal of two percent. Lagarde did not answer directly.

But at least her smile conveyed a certain sense of triumph and the attitude: We have beaten inflation. This has fallen from around ten percent to just 2.4 percent. “We are seeing a decline in inflation, we are in a disinflationary process,” Lagarde said.

So it was very clear: Lagarde and with her the council at the top of the central bank paved the way for an interest rate cut on June 6th. “All signals point to monetary easing,” says Florian Heider, Scientific Director of the Leibniz Institute for Financial Market Research SAFE in Frankfurt. Michael Holstein, chief economist at DZ Bank, made a similar statement. “The first interest rate cut will come in June, and the ECB and market participants have now prepared for this. Inflation has now almost reached the inflation target of 2 percent and the economy in Europe is weak.”

The ECB itself has used a new sentence in its monetary policy statement to set the conditions for when a rate cut is “appropriate”. The new sentence says in complicated central bank language: “If the updated assessment by the Governing Council of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission increases the Governing Council’s confidence in a sustained convergence of inflation towards the target would strengthen further, it would be appropriate to reduce the current restrictive monetary policy.” Lagarde himself quoted the sentence several times in the press conference and pointedly pointed out that the sentence was new. So there couldn’t be more fence post, or as Commerzbank chief economist Jörg Krämer writes: “A lot has to happen so that the ECB doesn’t lower its interest rates in June.”

As a result, the deposit rate, currently the most important key interest rate in the Eurozone, would probably fall by 25 basis points to 3.75 percent on June 6th. On Thursday, the ECB left all three interest rates unchanged, meaning the main refinancing rate as the classic key interest rate initially remains at 4.5 percent. The President reported that some voices in the Council had already spoken out in favor of an interest rate cut that day.

This leads back to the Spanish journalist’s question and the volatility of inflation rates. Lagarde said “a few potholes along the way” were included in the projections. In other words, if inflation were to be higher for a few months, that would not dissuade the ECB from its course.

But what if the inflation rate does not fall, but actually rises again and remains permanently above the target of two percent? After all, the prices for services recently rose by 4.0 percent and the so-called home-grown inflation – according to the ECB definition “goods and services produced for domestic consumption with low import intensity” – even increased by 4.5 percent. In addition, as Lagarde also admitted, there is the risk of an increase in energy prices due to the critical situation in the Middle East.

Against this backdrop, a rate cut in June could prove to be a monetary policy mistake. Krämer describes the looming interest rate cut as risky because consumer prices have recently risen significantly again not only in the USA, but also in the euro area, which is primarily due to the sharp rise in wages. He therefore expects fewer interest rate cuts than the consensus of economists. “In the long term, the ECB will not be able to ignore the unresolved inflation problem,” said Krämer.

If the ECB cuts interest rates too early, economists like Krämer argue that this could fuel a resurgence of inflation. In the worst case, it would even have to tighten up again, which would damage its credibility.

The ECB has already committed a “policy mistake” twice in its 25-year history: once with an interest rate increase in 2011 in response to expensive oil, while the Greek crisis was already escalating. And Lagarde himself hesitated for a long time to respond to the surge in inflation in 2021/22 by increasing interest rates. If economists like Krämer are right, the triumph over inflation would be a Pyrrhic victory.