Market Analysis

The European Central Bank (ECB) is widely expected to reduce interest rates again on Thursday. However, despite sluggish economic growth, persistent inflation concerns mean investors will be analyzing its communication for signs of further rate cuts.

In June, the ECB lowered its deposit rate to 3.75%, and several policymakers have already endorsed another reduction. The debate now seems to revolve around how quickly rates should be cut in upcoming meetings.

ECB President Christine Lagarde is likely to maintain the bank's current approach, emphasizing that decisions are made on a meeting-by-meeting basis and driven by incoming data, with no firm commitments. However, she may suggest that all meetings remain “live,” keeping the possibility of a rate cut in October open, even if some conservative policymakers argue for a more gradual approach, particularly while inflation in the euro zone continues to exceed the ECB’s 2% target.

Danske Bank's Piet Haines Christiansen noted that while a rate cut in October is possible, it is unlikely that the data between the September and October meetings will be weak enough to justify it.

Policymakers with a more dovish stance, mainly from southern Europe, are likely to push for quicker action, citing increasing recession risks and inflation nearing the 2.2% target. They argue that the current rates are excessively hindering growth. However, inflation-conscious hawks, still in the majority, point to a strong labor market and persistent price pressures in the services sector as reasons to remain cautious about cutting rates too quickly.

New Forecasts
The release of fresh economic forecasts is unlikely to provide a definitive answer. The ECB’s staff projections are expected to show slightly slower growth this year, with inflation following a similar trajectory to June’s forecast, on track to reach 2% sustainably by the second half of next year.

Few policymakers are expected to oppose further easing, but the central question remains how swiftly the ECB should proceed. Pimco portfolio manager Konstantin Veit suggested that while the ECB is not in a rush to reduce rates, it also wants to avoid keeping them too high for an extended period. He anticipates a third rate cut in December, coinciding with another round of staff projections.

Hawkish policymakers have signaled that quarterly rate reductions are appropriate, since key growth and wage indicators – crucial for the ECB's projections – are updated every three months.

Investors are also divided. Markets have priced in a rate cut by December, but the probability of an earlier move in October is fluctuating between 40% and 50%. Lagarde's primary challenge during her press conference will be to keep options open without raising undue expectations for October.

Societe Generale’s Anatoli Annenkov believes the ECB will likely stick to its quarterly pace of cuts, as domestic inflation and underlying labor costs remain too high. However, he noted that faster policy easing would require a more pronounced deterioration in the labor market, which has yet to occur.

Technical Rate Cut
The ECB’s upcoming rate adjustment is expected to lower the deposit rate by 25 basis points to 3.5%. Additionally, the refinancing rate is set to drop by a larger 60 basis points, as part of a previously announced technical adjustment aimed at narrowing the gap between the two rates.

For years, the difference between these rates has stood at 50 basis points, but the ECB announced plans in March to reduce this corridor to 15 basis points starting in September. While this move could eventually encourage more lending between banks, such a development is still a long way off. Currently, banks are sitting on €3 trillion of excess liquidity, which they deposit overnight with the ECB, making the deposit rate the bank’s primary policy tool for now.

Over time, as liquidity diminishes, banks are expected to borrow from the ECB at the refinancing rate once again, restoring its importance as the central bank’s benchmark rate. The narrower rate corridor should also improve the ECB’s ability to manage market rates more effectively.

Paraphrasing text from "Reuters" all rights reserved by the original author.