ECB concerned market bets on rate cuts risk derailing disinflation

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European Central Bank policymakers were concerned that investor bets on rate cuts as early as March had loosened financial conditions so much that they “could derail the disinflationary process”, minutes from their last meeting show.

Members of the ECB’s governing council decided to push back against market expectations of early interest rate cuts and agreed that June was likely to be the earliest they could know if inflation had been tamed, according to minutes of the December 15 meeting released on Thursday.

“Against this background, it was widely regarded as important not to accommodate market expectations in the post-meeting communication,” the ECB said. “It was stressed that there was no room for complacency.”

In the past week, several senior ECB officials have put this plan into action. Comments by ECB president Christine Lagarde suggesting that borrowing costs would not come down until the summer triggered a global sell-off in bond and equity markets on Wednesday.

The tension between the ECB and markets underlines how investors expect inflation to fall faster than the central bank is forecasting, which would allow policymakers to start slashing their benchmark deposit rate from its record-high level of 4 per cent this spring.

The ECB minutes show that policymakers in the eurozone were concerned that market expectations could derail disinflation long before a top official warned about the same issue this week. Gita Gopinath, first deputy managing director of the IMF, told the Financial Times that central banks should move cautiously on cutting rates for that reason.

Annual price growth in the eurozone slowed from a peak of 10.6 per cent in October 2022 to a two-year low of 2.4 per cent in November, before picking up to 2.9 per cent last month after the phasing out of government energy subsidies.

Policymakers debated at last month’s meeting how sticky inflation was likely to be in the “last mile” of its decline to their 2 per cent target. Most agreed wage growth would be a crucial factor and they expected it to start slowing in response to the recent fall of inflation.

But ECB policymakers also listed several upside risks to inflation, including geopolitical tensions that could raise energy prices, extreme weather events that could push up food costs and higher than expected growth in wages or profit margins.

“The remaining distance of inflation from the ECB’s target, the waning of disinflationary supply-side tailwinds and, overall, still-high levels of domestic inflation continued to call for maintaining a sufficiently restrictive stance,” the ECB said.

Carsten Brzeski, an economist at Dutch bank ING, said the minutes showed the ECB was “still far away from discussing rate cuts” at last month’s meeting and this was “unlikely to change” when council members meet again in Frankfurt next week.

The sharp increase in borrowing costs since mid-2022 has hit Europe’s building sector particularly hard, as shown by data the EU’s statistics office released on Thursday revealing EU construction production was down 2 per cent in November from a year earlier.

Construction activity fell in Germany, France, the Netherlands, Hungary, Poland, Austria and the Nordic region, contributing to a 1 per cent month-on-month decline in the EU overall, as high interest rates and weak economic growth weighed on the sector.

Separate data published by Germany’s federal statistical office showed the number of building permits for apartments continued to decline in November, falling 16.9 per cent from a year earlier, squeezing the supply of new housing.

There were 238,500 building permits granted in the first 11 months of last year, down more than a quarter from a year earlier and leaving the sector likely to fall well short of the German government’s 400,000 target.

German house prices have fallen 10 per cent from a peak in 2022. But Jochen Möbert, economist at Deutsche Bank, predicted the housing market would recover this year “given the shortages of houses, the relatively high wage growth and the low long-term Bund yields which fell substantially towards end-2023”.