The danger of premature ECB rate cuts

WITH inflation in the eurozone dropping from a peak of 10.6 per cent in October 2022 to 2.6 per cent in May 2024, the European Central Bank (ECB) is optimistic that inflationary pressures will continue to ease. Its March projections show inflation averaging 2.3 per cent in 2024, before falling to 2 per cent in 2025 and 1.9 per cent in 2026. Thus, the ECB is expected to cut its key policy rate, the deposit facility rate, from 4 per cent to around 3.75 per cent on Thursday (Jun 6). Markets foresee this as the first of many cuts that will substantially lower the ECB’S policy rates over the next two years. The signalling effect and timing of the move are indeed significant, because this marks only the fifth time since the ECB’S inception (26 years ago) that it has initiated a new rate-cut cycle. But, while a forward-looking monetary policy is commendable, it faces inherent limitations, particularly given the uncertainty of economic forecasts. After all, predicting inflation beyond a one-year horizon is notoriously difficult, and this uncertainty has only increased in recent years. The ECB’S own failure to address the recent surge of inflation in a timely and effective manner was partly owing to inaccurate forecasts. Model-based forecasts, by design, tend to revert to historical averages in the medium term, and history also suggests that long-term inflation projections often converge to the central bank’s targets. Thus, the ECB’S forecasts showing declining inflation are partly a result of historical bias. Moreover, the lingering effects of pandemic-related measures (such as inflated central bank balance sheets and higher fiscal deficits), coupled with economic sanctions on Russia, are also challenging to model and predict. Equally, additional geopolitical risks – including the Middle East conflict and escalating tensions between the United States and China – further complicate the inflation outlook, with most inflation risks tilting to the upside. Structural changes also point towards higher inflation. Obvious sources of inflationary pressure include tight labour markets (driven by aging populations); extensive investments in the energy transition, energy security and defence; deglobalisation; and the eventual costs of rebuilding Ukraine. Currently, the annual inflation rate in the eurozone remains above 2 per cent, and recent trends are worrisome. Looking at consumer price levels (instead of growth rates) shows that, after a slight decline in late 2023, consumer prices have accelerated in 2024, rising at an annualised pace of 3.1 per cent so far this year (measured by the seasonally adjusted Harmonised Index of Consumer Prices). With consumer inflation above 2 per cent and accelerating, historically low unemployment and rapid wage growth (negotiated wages increased by 4.7 per cent year on year in the first quarter), initiating a rate-cut cycle now could lead to another serious policy misstep. The ECB already erred previously, in 2021 to 2022, when it based its monetary policy on faulty forecasts, and it now seems poised to repeat the mistake. Relying on undependable forecasts and ignoring current economic realities is not a forward-looking policy; it is a hope-based one. Forecast uncertainty presents significant challenges for all central banks, since successful policymaking requires reasonably accurate foresight. As the reliability of forecasting wanes, effective risk management becomes crucial. Under conditions characterised by a high degree of uncertainty, monetary policy must avoid significant errors, above all. The ECB could make either of two potential mistakes: an overly restrictive policy or a premature easing. An overly restrictive policy could cause a recession and deflation, potentially threatening the stability of financial markets or real estate prices. While undesirable, this scenario does not pose an existential threat to the eurozone. The ECB has ample leeway, tools and experience to combat deflation, if necessary. Conversely, premature easing could reignite inflation, forcing the ECB to reverse its initial cuts and to hike rates to higher levels than today. This scenario really could threaten the eurozone’s stability, as highly indebted member states might face unsustainable debt dynamics, with bond markets questioning their ability to repay. Central banks would then come under more pressure from governments, leading to fiscal dominance. If they are reluctant to do what is necessary, inflation could become persistent. Persistent inflation, generated by an overly expansionary policy, is clearly the more perilous scenario. Yet, this is precisely the risk that the ECB will be taking by launching a new rate-cutting cycle now. A premature shift to easing could undermine its credibility and heighten future inflation risks. By overlooking the asymmetry of risks, the ECB is exhibiting poor risk management. Central banks should not allow market pressures to dictate their policies. Premature easing is a dangerous gamble.