Could the ECB cut rates before the Fed?

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Inflation is falling faster than forecast in Europe while exceeding expectations in the US, prompting investors to predict the European Central Bank could cut interest rates earlier than the Federal Reserve.

Eurozone inflation dropped to 2.4 per cent in the year to March, the fourth straight monthly fall and the latest evidence that prices are edging tantalisingly close to the ECB’s 2 per cent target.

In contrast, US inflation has exceeded forecasts since the start of this year, with the headline personal consumption expenditures metric that the Fed uses for its target rising from 2.4 per cent in the year to January to 2.5 per cent in February.

After the biggest rise in the cost of living for a generation, the diverging paths of inflation in the eurozone and the US have prompted investors to reduce the total interest rate cuts they expect from the Fed this year, while predicting the ECB will still ease policy more aggressively.

“There’s now ample evidence over the first three months of the year that the disinflation momentum remains stronger in Europe than in the US,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.

Fed chair Jay Powell signalled in a speech on Wednesday that stubbornly high US inflation may keep the central bank from cutting rates as quickly as previously thought. 

“We do not expect that it will be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably down towards 2 per cent,” Powell said. “Given the strength of the economy and progress on inflation so far, we have time to let the incoming data guide our decisions on policy.” 

Interest rate swap markets were on Wednesday pricing in almost 70 basis points of rate cuts by the Fed and Bank of England this year — equivalent to between two and three quarter-point cuts. For the ECB, they priced in nearly 90bp of cuts — equal to almost an extra quarter-point move.

Last year the Fed raised its policy rate to a 23-year high of 5.25 per cent to 5.5 per cent, while the ECB lifted its deposit rate to a record-high 4 per cent.

UK inflation fell to 3.4 per cent in February. The BoE has forecast consumer price growth will fall below its 2 per cent target in the second quarter but it is closely monitoring services inflation that remained worryingly high at 6.1 per cent in February, driven by rapid wage growth.

Katharine Neiss, chief European economist at PGIM Fixed Income, said the eurozone’s “encouraging” inflation data meant the bar was “pretty high” for the ECB to delay rate cuts beyond June — unlike the Fed.

“The increased conviction around the likelihood and timing of ECB rate cuts does stand somewhat in contrast with what we are seeing in the US.”

US price pressures are being kept elevated by strong growth in the world’s largest economy, which expanded gross domestic product by 2.5 per cent last year. The eurozone, in contrast, has stagnated after its GDP rose only 0.5 per cent last year, fuelling calls to boost economic activity with a looser monetary policy.

“With euro area growth being certainly more timid we think it will allow the ECB, as indicated, to cut rates in June while we could see the Fed cut being pushed out to July,” said Kaspar Hense, a senior portfolio manager at RBC Bluebay Asset Management.

Pablo Hernández de Cos, Spain’s central bank governor and ECB council member, responded to the latest fall in eurozone inflation by saying “the central scenario is that June could be the first interest rate cut”. 

The ECB is expected to signal it is getting close to cutting rates when its governing council meets in Frankfurt next week.

However, there are reasons for the ECB to remain cautious and wait until June before cutting rates for the first time since 2019.

The main one is rapid growth in services prices, which make up 45 per cent of the basket used to calculate eurozone inflation and rose at an uncomfortably high annual pace of 4 per cent for the fifth month in a row in March.

“Hawks will point to still-sticky services inflation as indicating a continued risk to underlying domestic inflation,” said Krishna Guha, vice-chair of equities at investment bank Evercore-ISI. “A significant drop in services inflation — signalling marked weakness in domestically generated inflation — would have been required to bring an April cut back to the table.”

Another reason for the ECB to be patient — despite calls from some board members, such as Piero Cipollone, to start cutting rates “swiftly” — is a desire to avoid a divergence with the Fed, which could cause foreign exchange and bond markets moves that risk a resurgence of inflationary pressures.

“I don’t think the ECB would dare to cut if the Fed changes communications before the summer,” said Ludovic Subran, chief economist at insurer Allianz, though he predicted a weakening US labour market could also allow both the Fed and the ECB to cut rates by July.