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The ECB held its main policy rates today at its October meeting, marking the first pause after ten successive rate hikes since the cycle began in July 2022.
The decision to keep the deposit rate at 4% met consensus expectations that had formed after the ECB effectively called an end to its hiking cycle at its September meeting, a view that was later confirmed by September’s inflation data undershooting the central bank’s staff projections. With the latest round of PMI data suggesting that eurozone economy is now headed for a technical recession if current momentum is sustained, and lending surveys and monetary aggregates suggesting policy actions are being forcefully transmitted, we think the focus for ECB policy is likely to shift to the timing and magnitude of rate cuts in 2024. However, with only one significantly constructive inflation report to hand and the labour market still generating elevated levels of wage growth, it was unsurprising to see President Lagarde and the Governing Council avoid giving this debate much air time, labelling this discussion as “absolutely premature” in the press conference. In fact, on this topic, President Lagarde reiterated previous commentary by Chief Economist Philip Lane by stating that the ECB is awaiting data on collective bargaining agreements and annual negotiations in 2024 before actively discussing the timing of rate cuts. This suggests rates are likely to remain on hold at least until Q2 2024.
Given the strategic ambiguity over the future path of policy and recent commentary by policymakers, the emphasis of today’s decision had shifted somewhat from policy rates to the reduction of the Eurosystem’s balance sheet and the level of liquidity in the system.
Here, President Lagarde stated that neither an earlier end to PEPP reinvestment or the level of minimum reserve requirements had been discussed at this meeting. Again, this is unsurprising given the ECB has only just begun to pause and observe the effects of its previous actions on the financial system and the real economy, while recent indigestion in eurozone bond markets, partly as a result of a duration sell-off in Treasuries, have also made this an inopportune time to discuss passive balance sheet reduction. In terms of earlier PEPP reinvestments, we don’t expect a decision to be made until early 2024, while a decision on raising the level of the minimum reserve requirements is likely to be tied to the outcome of the ECB’s review of its operational framework, expected to be released in Spring of next year.
On the whole, today’s ECB decision confirms our view that barring any considerable upside shock to inflation, policy rates are now at their terminal levels.
Furthermore, with major eurozone economies teetering on the edge of or actively in recession, rate cuts are likely to take place earlier than the ECB’s September projections suggest. Under our base case that the eurozone enters a technical recession in Q4, we expect the ECB to begin easing policy as early as Q2 next year. However, given data has suggested that the ECB has already overtightened policy, there is a considerable risk that rates are cut as soon as Q1. The magnitude and extent of policy easing thereafter remains highly uncertain. The severity of the eurozone recession in coming months and its impact on inflation and the labour market will therefore be crucial in forming our forecasts on eurozone rates beyond the first cut and the near-term outlook for EURUSD.
Author:
Simon Harvey, Head of FX Analysis