In its third consecutive meeting, the Governing Council of the European Central Bank (ECB) cut all three key interest rates as expected by a quarter of a percentage point. They are now in a range of 3.00%-3.40%.
Although before the announcement of the decision, there were some speculations that monetary policymakers might resort to a more rapid easing, the gradual tapering path ultimately prevailed. In fact, Christine Lagarde, the head of the Central Bank, admitted that while there were discussions about cutting the rates by half a percentage point, it was decided to do so by a quarter.
Mission Not Yet Accomplished
Alongside the announcement of the rate cut, another message from the ECB President was also emphasized: the mission to curb inflation is not yet accomplished. The central bank is aiming for so-called price stability of 2% annual growth. Although this figure was higher in November’s preliminary assessment at 2.3%, it is expected that it will inch closer to the desired level in the coming year. The rate of price increases had already fallen below the threshold of 1.7% in September but picked up again to 2% in October.
However, according to the ECB’s assessment, the rise in annual inflation recorded this autumn was due to a base effect, i.e. a comparison of prices with the previous year, rather than to current developments in prices.
This ECB assessment is also reflected in the updated inflation forecasts. Compared to September, they have been revised downwards, with average annual inflation forecast at 2.4% this year, compared to the previously expected 2.5%. Next year, inflation is also expected to be 0.1% lower, at 2.1%. The revised forecasts suggest that monetary policymakers believe some progress has been made in the fight against inflation since September. Nevertheless, a premature belief in mission accomplishment risks a new wave of inflation.
Money Supply Is Back on Growth Path
It is becoming increasingly difficult to expect a further gradual slowdown in inflation as the main factor that has been holding it back fades into oblivion. The record inflation in the euro area was driven by cheap money during the pandemic when the money supply in the economy increased by as much as a quarter. The rise in prices was dampened by turning the Central Bank’s actions upside down and halting the “printing” of money. This allowed to stabilize the price growth, which had reached double-digit highs.
After the central bank had started easing its policy in the middle of the year, it did not take long for the money supply (M1) to return to growth. October was the first month since August 2022 when the annual change in this indicator returned to positive territory at 0.3% (€10.4 trillion). This indicator includes cash and funds held in current accounts. Its decline indicated that people were relatively less able to spend money on consumer goods and services, which held back price increases.
At the same time, the broad money supply indicator M3, which also includes time deposits and short-term debt securities, has continued to accelerate at an annual rate of 3.8%, reaching €16.6 trillion. It can be concluded that the factors that have been suppressing inflation have run their course and that the effects of the recent monetary tightening are wearing off. Further cuts in interest rates will continue to put the money supply back on a growth path.
However, one factor will ensure that the ECB’s monetary policy will remain two-sided. Cutting interest rates obviously implies easing monetary policy. On the other hand, the policy of quantitative tightening will continue to be pursued through another channel. During the COVID period, monetary policymakers not only kept interest rates at zero but also carried out quantitative easing on an unprecedented scale, with a record €1.7 trillion worth of bonds being bought through the pandemic program. This was one of the factors behind the rapid increase in the money supply.
At the end of last year, the Governing Council decided to reduce the reinvestment of the pandemic programme by €7.5 billion per month from this June and to end it completely by the end of 2024. Reinvestment meant replacing maturing bonds with new ones, thus maintaining the amount of liquidity injected into the financial system. Quantitative tightening – the reduction of the Central Bank’s balance sheet – will therefore contribute to a reduction in liquidity. This will be one of the factors that will at least somewhat offset the impact of the reduction in base rates.
Debate on Neutral Interest Rate Is Still on The Horizon
A key question that remains unanswered after this meeting is how far the ECB is willing to go in lowering base rates. According to Ch. Lagarde, there was no discussion on neutral interest rates at the meeting, yet at the same time she also stressed that this issue could not be avoided in the near future.
This is a rate of interest that would neither stifle nor artificially stimulate economic growth. According to the Governor, this issue will be raised more and more frequently as ECB rates move closer to what is theoretically considered a neutral rate, with the commonly identified range of around 2%. Yet, as Ch. Lagarde points out, it is impossible to determine it precisely, which is the first problem that monetary policymakers will face in further interest rate cuts.
The members of the Governing Council are indeed most likely to concentrate more on arguing about whether base rates should be lowered below this threshold rather than on the search for a neutral interest rate itself. The need to return to a cheap money policy is increasingly on the minds of economists as well as officials. Bloomberg surveys show that a majority of them believe that interest rates will have fallen to stimulus levels by the end of 2025. In October, it was still thought that they would be kept at a neutral rate. The expectation is that interest rates will continue to be cut by 25 basis points at each meeting in the coming year, before finally reaching 2% in June.
Nonetheless, it must be understood that low interest rates are not a cure for all the economic problems plaguing the euro area. If companies do not invest for other reasons, such as excessive restrictions, bureaucratic red tape, rather than lack of credit, cheaper money will not save the economy. One can only recall that a return to cheap money policy would devalue people’s savings and leave the fundamental problems of the economy unresolved.