The ECB has made its decision: rates will fall by 25 basis points. An unprecedented decline in more than 5 years. The ECB's decision to ease monetary policy comes as inflation still remains above target, and the United States remains rigid on its monetary policy. Future impacts on financial markets and the value of the euro could be significant if the monetary policy gap between the FED and the ECB becomes persistent. Decryption of the ECB decision.
Monetary policy: pivot time for the ECB
The Governing Council of the ECB decided to lower the three key interest rates by 25 basis points. The main refinancing rate will thus increase from 4.5% to 4.25%. This decision comes as inflation has fallen by more than 2.5 percentage points since September 2023. However, as the ECB points out, inflationary pressures remain strong with wage growth, keeping inflation above the goal for next year at least. The ECB's new projections for 2024 and 2025 show an increase in general inflation to 2.5% in 2024 and 2.2% in 2025, while core inflation would reach 2.8% in 2024 and 2. .2% in 2025. For its part, economic growth is expected to increase to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026.
“The Governing Council today decided to lower the ECB's three key interest rates by 25 basis points. Based on an updated assessment of the inflation outlook, underlying inflation dynamics and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of keeping rates stable. »
As usual, the ECB recalls that rate decisions will be based on the evolution of the inflation outlook and incoming economic and financial data, as well as the transmission of monetary policy. We will also note that the council will also reduce the holdings of securities of the pandemic emergency purchase program (PEPP) by 7.5 billion euros per month on average in the second half of the year.
Towards a new era of relaxation?
Between July 2022 and October 2023, the ECB increased its main refinancing rate from 0% to 4.5%. This is the most restrictive monetary policy in the history of the institution. This restriction appeared more than necessary in view of galloping inflation, which reached up to 10% in October 2022. Despite the sharp decline in inflation, it seems to persist at around 2.5% to 2.6% in 2024. Inflation therefore persists above the ECB's target of 2%.
The deviation from the inflation target is significant if we consider underlying inflation (inflation excluding raw materials and energy). Core inflation reaches almost 3% in May 2024.Furthermore, the French government's 10-year rate stands at 3%, which is lower than the ECB's floor rate, but higher than the inflation target. Despite persistent inflation, it is likely that the ECB will take into account implicit criteria:
- First, the low level of economic growth compared to the United States. This lower growth would suggest, although not within the ECB's mandate, a more relaxed monetary policy.
- Then, maintaining rates that are permanently higher than inflation can significantly harm the viability of public budgets and a certain number of businesses. It is conceivable that there will be political pressure to lower rates. Remember that the interest charge will represent the first budget of many States in a few years.
François Villeroy de Galhau, the governor of the Banque de France, insists that the ECB has sufficient room for maneuver. In other words, the ECB must lower its key rate quite significantly. Pressures to lower rates in the euro zone are therefore persistent, both for implicit economic and political reasons.
“ Today there is a broad consensus that the risks are balanced. We must guard against two pitfalls, that of haste, lowering rates too early and there is the pitfall of tension, it's acting too late and weighing too much on the activity. »
François Villeroy de Galhau – François Villeroy de Galhau considers it “very likely” that the ECB will start lowering its rates “in the spring” (bfmtv.com)
Pivot: the consequences for the euro
Monetary policy has a major impact on the value of money. Indeed, a drop in the interest rate, for a fixed foreign interest rate, leads to a devaluation of the local currency. Investors will therefore prefer to invest abroad at a higher rate, resulting in capital flight.
Therefore, the different rates between economic regions indirectly determine the value of the currency. The chart below shows the policy rate differential between the FED and the ECB, as well as the USD/EUR exchange rate. The remuneration of capital between economic regions is one of the major determinants of the value of money. In addition, it may appear that markets anticipate central bank rate movements. This type of phenomenon can cause the exchange rate to fall or rise above or below what the rate differential suggests.
For example, the significant rise in the dollar in 2022 was the consequence of the ECB delaying the FED in reacting against inflation. A reduction in ECB rates would therefore be likely to reduce the value of the euro against the dollar.
Lowering rates too much: an inflationary risk?
Despite everything, the major challenge for a relaxation of European monetary policy is the appearance of a potential lasting gap with the FED. Indeed, if the American central bank delays lowering its rates, or if the ECB lowers rates intensively, then a significant rate gap could appear. Too large a rate difference would harm the euro. In addition, a significant devaluation of the euro could lead to imported inflation, in particular due to the mechanical increase in the cost of imported raw materials.
What impact on financial markets?
Monetary policy is a major issue in financial markets. While financial markets anticipated a rate cut by the FED in 2024, the robustness of the American economy swept away hopes of a rate cut in the summer. The ECB nevertheless seems to confirm expectations. A dynamic of monetary easing is thus likely to encourage an increase in financial markets.
“ Bitcoin thus has an increased dependence, although slightly less than that of the S&P 500, on the money supply. The money supply thus determines, and to a large extent, the bullish potential of bitcoin. This relationship can clearly call into question the independence of bitcoin, but a rather lax monetary and budgetary context generally benefits financial assets. »
Does money supply influence bitcoin? – Tremplin.io
The reduction in rates for the ECB is therefore above all a favorable signal for the economy. Indeed, credit conditions will be eased throughout the economy, favoring greater monetary creation. The implicit long-term risk is obviously that of observing a new inflationary wave. Additionally, lower rates could benefit more leveraged companies like small caps. The most speculative or volatile assets would also benefit from a lasting easing of monetary policy.
However, the fall in rates is not necessarily favorable to financial markets. Indeed, a reduction in rates with continued growth is similar to a “soft landing”or soft landing. However, a drop in rates can also be a signal of a deterioration in economic conditions, which generally leads to a sharp contraction of the markets (“hard landing”).
In conclusion
The ECB's rate cut comes as no surprise to the financial markets. The implications of this decision are multiple. First, the ECB is pushing for a potentially lasting rate cut while the FED remains inflexible. A lasting difference in the key rate between the different central banks could therefore harm the value of the euro. At the same time, the rate cut comes at a time when growth in the eurozone is almost standing still.. In addition, the interest burden weighs heavily on many states and businesses.
The ECB's rate cut is therefore an essentially positive signal for the time being. However, a significant monetary policy gap with the FED would bring structural risks for the euro. A drop in rates does not protect the euro zone economy against an economic slowdown in ten months.
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