The European Central Bank sent a strong signal to the world that it would cut rates next week from their historic highs. Its chief economist dismissed fears that cutting interest rates before the US Federal Reserve might backfire.
ECB is now almost certain to become one of the first central banks to reduce rates after being criticized for being the last to increase them following the largest inflation surge in a generation.
Philip Lane said in an interview before the bank’s historic June 6 meeting that “barring major surprises, there is enough evidence in the current situation to remove the highest level of restriction.”
Investors bet heavily that the ECB, at its meeting next week, will reduce its benchmark deposit rate from its high record of 4 percent to a quarter point after Eurozone’s inflation came close to the bank’s 2 percent target.
In response to the falling inflation, central banks in Switzerland, Sweden, Czech Republic and Hungary have reduced their borrowing costs this year. The Bank of England and the Fed are unlikely to reduce rates until the summer, while the Bank of Japan will likely continue to raise them.
When asked if he felt proud that the ECB had been able to reduce rates sooner than other central banks, Lane replied: “Central Bankers aspired to be as boring and I hope they aspired to have as little ego possible.”
He said that the Eurozone had been more affected by the energy shock caused by Russia’s invasion in Ukraine. He said that Europe had paid a high price for dealing with the energy crisis and the war.
“But in regards to that first step [in beginning to reduce rates], that’s a sign that the monetary policy is working in order to ensure that inflation falls in a timely fashion. I consider that we’ve been successful in this regard.
Lane warned that ECB policymakers must keep rates low this year in order to maintain a steady inflation and avoid a situation where the bank’s inflation target is exceeded, which he said “would be problematic and painful to remove”.
He said that the rate at which the central banks will lower Eurozone borrowing rates this year, would be determined by the data collected to determine “if it is proportional and safe to move downwards within the restricted zone”.
Lane, the person responsible for drafting the proposed rate decision and presenting it to the 26 members on the governing council before they decide next week, said that “things will be bumpy” and “things will be gradual”.
He added that the best way to frame this year’s debate is to say we need to remain restrictive throughout the year. “But we can go down a little bit within the restrictiveness zone.”
Lane stated in a Monday speech: “If there are any upward surprises with the underlying inflation, then rate cuts will slow down.” . . They will “be faster if there are negative surprises” in inflation and demand. He told reporters in Dublin: “The discussion of a rate reduction next week isn’t a declaration victory.”
Lane stated that despite recent data showing Eurozone wages growing at a near record pace, “the overall trend of wages still indicates deceleration which is crucial”. He added that the ECB wage tracker also supports this.
Analysts have warned that if ECB cuts rates more aggressively than the Fed, it could lead to a depreciation of the euro and increase inflation by increasing the cost of imports.
Lane stated that the ECB will take into consideration any “significant” change in exchange rates, but noted “there has only been very little movement”. The euro is up by a fifth compared to the US dollar since April, when it hit a six-month low.
He said that delays in the anticipated timing for Fed rate reductions had driven up US bond yields, and this had led to a rise in long-term yields on European bonds.
He said that “that mechanism means you get an extra tightening of the US conditions for any interest rates we set,” indicating that the ECB may have to offset this by cutting its short-term rate. “All other things being equal, you have to change your thinking about the short-term if the long-term tightens up more.”
The eurozone inflation rate has dropped from over 10% at its peak of 2022 to 2,4% in April. However, it is expected that the May data will show a slight increase to 2,5%.
Lane stated that the ECB will have to maintain its restrictive policy until 2025 due to the “still considerable amount of cost pressure,” which is caused by rapid wage growth driving up service prices.
He said that next year, when inflation is visibly approaching its target, he would focus on lowering the interest rates to the level that was consistent with the target.
The ECB’s assessment of its neutral rate (the point where savings and investments are balanced and output reaches the potential of an economy and inflation is target) will determine how far it cuts rates.
The neutral rate is estimated to vary, but Lane said that it would likely imply a rate of policy at or above 2%. However, this could be even higher if a “vigorous green transition” towards renewable energy or huge gains from generative AI prompted an increase in investment.
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