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The European Central Bank (ECB) has been sending mixed signals about its monetary policy stance in recent weeks. On one hand, it has been preaching patience and caution, saying that it is too early to withdraw stimulus and that inflation pressures are transitory. On the other hand, it has not ruled out the possibility of cutting interest rates further into negative territory in April, when it will update its economic projections and review its policy tools.
What is behind this apparent contradiction? And what are the implications for the eurozone economy and financial markets?
The ECB has several reasons to be patient and avoid any premature tightening of monetary conditions. First, the eurozone is still facing a severe health crisis, with new variants of the coronavirus threatening to prolong lockdowns and delay the recovery. The vaccination campaign has been slow and uneven across countries, and there is still a high degree of uncertainty about the evolution of the pandemic.
Second, the eurozone economy is still far from its pre-crisis level of activity and faces significant downside risks. The ECB expects GDP to contract by 0.7% in the fourth quarter of 2023 and by 0.9% in the first quarter of 2024, before rebounding by 4.6% in the second quarter. However, this outlook hinges on the assumption that lockdowns will ease gradually and that fiscal support will remain ample. Any deviation from these assumptions could lead to a worse outcome.
Third, the ECB is not convinced that the recent surge in inflation is durable and reflects a sustained increase in underlying price pressures. The headline inflation rate jumped from -0.3% in December 2023 to 0.9% in January 2024, mainly due to temporary factors such as higher energy prices, changes in tax rates, and base effects. The core inflation rate, which excludes volatile items such as food and energy, remained subdued at 1.4%. The ECB expects inflation to rise further in the coming months, but to decline again later in the year and remain below its target of close to but below 2% over the medium term.
Despite these arguments for patience, the ECB has also hinted at the possibility of cutting its deposit rate, which is currently at -0.5%, by another 10 basis points in April. Why would it do that?
One reason is that the ECB wants to maintain an accommodative monetary policy stance and avoid any unwarranted tightening of financial conditions. The ECB has been using its pandemic emergency purchase programme (PEPP), which has a total envelope of €1.85 trillion, to buy government and corporate bonds and keep borrowing costs low for households, businesses, and governments. However, this programme is due to end in March 2024, and the ECB has not yet decided whether to extend it or replace it with another instrument.
Another reason is that the ECB wants to counteract the appreciation of the euro, which has gained about 10% against the US dollar since March 2023. A stronger euro makes eurozone exports less competitive and imports cheaper, which weighs on growth and inflation. By cutting interest rates further into negative territory, the ECB hopes to discourage investors from holding euros and weaken the exchange rate.
A third reason is that the ECB wants to signal its commitment to its inflation target and avoid any de-anchoring of inflation expectations. The ECB has been undershooting its target for almost a decade, and some market participants and analysts have questioned its ability and willingness to achieve it. By cutting rates, the ECB would show that it is ready to use all its tools and that it is not complacent about low inflation.
A rate cut by the ECB in April would have both positive and negative effects on the eurozone economy and financial markets.
On the positive side, it would lower borrowing costs for households, businesses, and governments, which could stimulate spending and investment. It would also weaken the euro, which could boost exports and inflation. It would also enhance the credibility of the ECB and anchor inflation expectations.
On the negative side, it would reduce the profitability of banks, which could impair their ability to lend and support the recovery. It would also increase the risk of financial imbalances and asset bubbles, as investors would search for higher returns in riskier assets. It would also create political tensions within the eurozone, as some countries, especially Germany, are opposed to negative interest rates and see them as a distortion of market signals.
The ECB will have to weigh these pros and cons carefully before making its decision in April. It will also have to communicate clearly its rationale and its expectations for future policy moves. Whatever it decides, it will have to be prepared to adjust its policy stance as the economic situation evolves and new information becomes available.
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