Download the PDF
ECB cuts rates in September for the second time since June.
No major economy has suffered more from the post-COVID inflation surge than Europe. Not only did COVID wreak havoc on supply chains across the region, as it did around the world, but the start of the Russia-Ukraine war in 2022 and associated trade sanctions sparked an unparalleled energy crisis within Europe. Headline inflation in the euro area surged to 10.6% by October 2022, led by a jump in retail energy prices of more than 40%.
Given that backdrop, the performance of the euro area economy over the past two years has been remarkable. Yes, the economy ground to a halt, with real GDP tracking sideways from late 2022 to late 2023. For those who want to get nit-picky, some may even claim the region experienced a technical recession, with real GDP falling for two consecutive quarters in Q4 2022 (-0.4% qsaar) and Q1 2023 (-0.1% qsaar).
But who are we are kidding? Declines of that magnitude are not anywhere near a recessionary episode, especially given the context of ongoing employment growth. Unemployment across the euro area has continued to grind lower following the COVID spike, reaching a record low of 6.4% in July 2024.
For all the central bank bashing that economic commentators can sometimes dish out, we also need to give credit where credit is due. The European Central Bank (ECB) needs to be commended for their delicate balancing act over the past three years, as it is looking increasingly likely that they will pull-off a miraculous soft-landing for the region.
Confronting the spike in inflation and some signs of deteriorating inflation expectations, the ECB commenced its tightening cycle back in July 2022, gradually lifting the deposit rate from -0.5% to 4% by September 2023. While this policy tightening contributed to the stalling of growth, authorities have been successful in dampening inflationary pressures, with the headline inflation rate dropping to 2.2% in August 2024 and the core inflation rate easing to 2.8%.
Although inflation remains higher than the ECB’s 2% inflation target, particularly for services prices, the ECB has started to reduce the degree of monetary policy restrictiveness by cutting rates by 25bps in June and by a further 25bps this week. The ECB is explicitly acknowledging the lags with which monetary policy operates, seeking to ease policy back to more neutral settings at the same time as achieving the last-mile reduction in inflation and preserving modest growth across the economy.
The ECB staff forecasts are instructive as a guidepost to their thinking. The ECB continues to forecast a decline in inflationary pressures over the coming year, albeit with some near-term volatility due to base effects associated with energy price movements last year. Headline inflation is forecast to fall to 2% by the end of 2025, while core inflation is forecast to fall to 2.2% by the end of 2025 and reach the 2% target by mid-2026.
The ECB staff expect growth in the euro area economy to continue to gradually recover. Real GDP growth has already started to improve over H1 2024, rising at a quarterly 0.3% and 0.2% pace over the March and June quarters respectively. While the recovery to date has largely been driven by external demand, improving prospects for consumer spending due to rising real incomes is expected to drive the medium-term outlook. Growth over H2 2024 is expected to be similar to that seen in the June quarter, with the recovery expected to pick-up pace next year and in 2026. In annual terms, the ECB forecasts real GDP growth to pick-up from 0.5% in 2023, to 0.8% in 2024, 1.3% in 2025 and 1.5% in 2026.
QIC’s forecasts are very similar to the latest ECB staff projections. We expect real GDP growth to average 0.8% in 2024 and 1.4% in both 2025 and 2026. Our inflation forecasts are also close to those by the ECB, as we also expect headline inflation to fall to 2% by the end of 2025. Our forecasts incorporate an ongoing gradual easing cycle by the ECB over the coming year, with cuts proceeding at a quarterly pace and a terminal deposit rate of 2.25% by December 2025.
President Lagarde did little to alter our expectations for ECB easing over the coming year. The latest ECB staff projections largely confirmed their views, with only minimal forecast revisions since the June meeting. President Lagarde didn’t provide any explicit forward guidance around the timing of the next move, other than that they will remain “data-dependent” and that they will take a “meeting-by-meeting” approach. We continue to expect the ECB to pause in October, with the next cut likely to occur in December.
Although it is too early to pop the Champagne and declare a victory over the inflation dragon, the ECB can certainly breathe a sigh of relief. And, for once, the ECB is leading the way for the other major central banks to follow. Next week, it will be Chair Powell’s turn to start the monetary policy easing cycle in the US.