The European Central Bank cut interest rates on Thursday as widely expected, with the key deposit facility rate cut by 0.25 percentage points to 3.5%. Under a new regimen on spreads between the ECB’s three rates, the main refinancing rate and marginal lending facility rate were each cut by 0.60 percentage points to 3.65% and 3.90% respectively.
The bank’s decision was unanimous, President Christine Lagarde added in her press conference in Frankfurt.
In its meeting today, the ECB also slightly lowered its growth outlook, while keeping headline inflation guidance unchanged and raising its forecast for core inflation this year and next.
“Following the first cut in June, the ECB wisely gave it a couple of months to sit back and monitor the effects. Their view is clear, it’s better to move slowly and steadily in one direction, rather than move too quickly and have to change course along the way,” Morningstar strategist Michael Field commented, adding that economic data since June has validated this course of action.
“Inflation bumped around, but has ultimately fallen to a level very close to the central bank’s target, while economic growth has remained positive, but benign,” Field added.
Spreads Between Rates to Be Reduced
As the ECB announced in March this year, the rate on the main refinancing operations (MRO) will be adjusted such that the spread between the rates on the MRO and the deposit facility will be reduced to 15 basis points from the current spread of 50 basis points.
ECB president Christine Lagarde declined to detail the bank’s future rate-cutting path, echoing previous statements that the ECB’s governing council will follow a data-dependent, meeting-by-meeting approach.
As of September 18, the three ECB key interest rates will stand at:
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Main refinancing rate: 3.65%, down by 0.60 percentage points from 4.25%
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Interest rate for the marginal lending facility: 3.90%, down by 0.60 percentage points from 4.50%
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Deposit facility rate: 3.50%, instead of 3.75%
At present, the most important rate is the interest rate on the deposit facility, which defines the interest banks receive for depositing money with the central bank overnight. It is also the most important interest rate for savers as it has a direct impact on savings or checking accounts that accrue interest.
European stocks were largely unchanged, as the moved had been expected. The euro initially strengthened against the dollar.
This is the second interest rate cut for the deposit facility in five years, after June’s initial cut, while the two other rates were last lowered in 2015. This follows 10 rate hikes since the Frankfurt-based institution began its rate hiking cycle in July 2022.
85% of economists polled by Reuters had expected the rate cut, and a vast majority is now looking at December for a third rate reduction of 0.25 percentage points this year.
Markets, meanwhile, were pricing in nearly four cuts in 2024 earlier this week, assigning some likelihood to an additional step in October.
ECB Trims Growth Outlook, Slightly Hikes Core Inflation Outlook
According to the latest Eurosystem staff projections, headline inflation will be averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026, as in the June projections. “Inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates. Inflation should then decline towards our target over the second half of next year.”
“For core inflation, the projections for 2024 and 2025 have been revised up slightly, as services inflation has been higher than expected. At the same time, staff continue to expect a rapid decline in core inflation, from 2.9% this year to 2.3% in 2025 and 2.0% in 2026,” the statement read further.
Previously, the ECB had forecast core inflation for 2024 and 2025 at 2.8% and 2.2%, respectively.
“Domestic inflation remains high as wages are still rising at an elevated pace. However, labour cost pressures are moderating, and profits are partially buffering the impact of higher wages on inflation. Financing conditions remain restrictive, and economic activity is still subdued, reflecting weak private consumption and investment.”
Staff project that the economy will grow by 0.8% in 2024, rising to 1.3% in 2025 and 1.5% in 2026. This is a slight downward revision compared with June’s projections for 0.9%, 1.4% and 1.6%, mainly owing to a weaker contribution from domestic demand over the next few quarters.
Fed Expected to Cut Rates Next Week
The ECB acted ahead of its US counterpart, which is expected to initiate rate cuts at its next meeting on September 17 & 18. “With inflation normalizing, there’s little reason to keep rates at highly restrictive levels, which risks triggering a recession,” says Preston Caldwell, chief US economist at Morningstar.
The Swiss National Bank was the first major bank to announce a rate cut in March, followed by Sweden’s Riskbank in May. The Bank of England on the other hand was the last major European central bank to lower rates when it announced it would cut rates to 5% on August 1. Another BoE rate cut on September 20 would surprise markets.
How Far Will European Interest Rates Fall?
Morningstar’s Field says “the risk of the economy overheating because of further rate cuts appears low, suggesting that economists’ expectations of one more rate cut before the end of the year is highly probable. The ECB’s pattern of cut, monitor, and repeat is likely to continue.”
Most analysts expect that the ECB will continue its rating cutting cycle in 2025 with three or more 0.25 percentage points reductions until September 2025. Fidelity expects three more quarterly cuts in 2025, bringing the interest rate down to a targeted 2.50% in September 2025, Carsten Roemheld of Fidelity said last week.
Analysts at DWS agree. In 2025, rates will fall by 25 percentage points each quarter until the target interest rate of 2.50% is reached in September 2025, Ulrike Kastens, European Economist at DWS, forecasts. “The ECB Governing Council will definitely want to avoid lowering interest rates too quickly and thus accepting a renewed rise in inflation,” she told Morningstar in an interview on September 5.
Bastian Freitag, Head of Fixed Income Germany at Rothschild & Co, said he also anticipates cuts of 25 basis points each in September and December as well as further quarterly steps in 2025. Although inflation is likely to pick up again slightly at the end of the year due to base effects, the rate is gradually moving towards 2%, he said. Risks are posed by service price inflation, oil prices, a slight increase in money supply growth and wage trends, Freitag told Morningstar on September 5.
How Will Interest Rate Cuts Affect Markets?
Equity markets tend to rise on anticipated rate cuts. In bond markets, falling interest rates mean lower yields, which pushes bond prices higher. Lower rates also make existing bonds, and particularly those already issued during a period of high rates, more attractive for yields.
Meanwhile cash savings rates on bank accounts will likely decrease, to the detriment of savers. The rates that savers receive depend mostly on the deposit facility, which defines the interest banks receive for depositing money with the ECB overnight.
Borrowers, by contrast, stand to benefit from lower rates as consumer debt and mortgages become cheaper.
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