The market is giving a high probability to another ECB Deposit rate cut at its next meeting (12th September) , perhaps influenced by the previously announced decision to reduce the refinancing rate at that point, because there is nothing in the Central Bank’s decisions or messaging to support that view or indeed that rates will be a lot lower by this time next year.
The ECB staff forecasts project inflation oscillating around the current 2.5% over the remainder of this year before falling slowly to 2% by the final quarter of next year and then marginally below target in 2026. Given the presumed lags in monetary policy that might argue for easier policy now but given the large forecasts errors in 2021 and 2022 the Governing Council seems to have lost faith in any model based forward projections. The forecast decline in inflation is also not based on any economic weakness (growth picks up and unemployment actually falls ) but driven by a combination of higher productivity growth and a marked deceleration in wage inflation ; compensation per employee falls from 4.8% this year to 3.5% next and then 3.2%.
In the absence of any faith in forward projections the ECB states that ‘the Governing Council will continue to follow a data-dependent and meeting-by-meeting approach’ and will not pre-commit to a particular rate path. Yet a host of Council members clearly signalled well ahead of the June meeting that a rate cut was very likely , duly delivered, but inflation had surprised to the upside,wage inflation had re-accelerated in the first quarter and the Staff raised their inflation forecast, albeit modestly.The published account of that meeting revealed, not surprisingly, that some members were uneasy about what appeared to be a decision at variance with the data-dependent mantra.
Perhaps as a consequence, post meeting rhetoric from Council members generally pushed back on the idea that the Bank had embarked on an easing cycle, and today’s July policy meeting reinforced the data dependent message. However, the announcement also explicitly referred to ‘elevated’ service inflation, which has moved back above 4%, and ‘high’ domestic price pressure.
So if the inflation rate over the next few months does pan out as the ECB expects (i.e stay around 2.5%) why would they cut rates?. One argument is that the ECB itself believes that monetary policy is restrictive, with an emphasis on ‘real’ rates, which have risen given the steep fall in actual inflation. So a Deposit rate of 3.75% translates into a real rate of 1.75% if inflation does fall to target. This approach also utilises the idea of a ‘neutral’ real rate, at which policy is consistent with sustainable real GDP growth and target inflation, but that rate is not observable and estimates of where it might be vary, although most argue it is perhaps around 1% or even lower, consistent therefore with a Deposit rate of 3% or below.
That theoretical approach sits uneasily with ‘data dependence’ however, and as long as the latter remains the mantra any rate decision would appear to be dependent on the latest inflation reading, or at least the service component,although the current inflation figure is backward looking, making a nonsense of the idea that monetary policy be set to influence activity and prices 18 months or so in the future.