Although markets expect both the Fed and the ECB to cut rates over the summer, macro developments could change that forecast.
As inflation continues to ease across the developed world, markets are eager for the rate-cutting cycle to begin. The US Federal Reserve and European Central Bank (ECB) will review monetary policy at their summer meetings, and investors expect both to start cutting at that stage. That’s a realistic central case, in our view, based on published economic data.
But another factor could influence the batting order: each central bank has its own specific mandate that determines its policy response to changes in the economy.
The US economy—particularly labor markets—remains strong, prompting concerns that US inflation won’t fall as fast as expected and that the Fed may delay its first cut, perhaps for some time. In those circumstances, would the ECB stand still?
Varying Mandates Create Different Motivations
While the Fed’s dual mandate includes both inflation and unemployment targets, the ECB is mandated to focus exclusively on price stability, keeping inflation near but below 2%. So, we think the ECB would likely cut rates if the Fed were to delay the start of its cutting cycle, as long as euro-area inflation stays on a sustainable downward course toward the target.
The ECB’s decision-making should follow three principles. Essentially, the governing council must evaluate: 1) how effectively monetary policy is working to curb inflationary pressures; 2) if the underlying core components of inflation are falling and; 3) the outlook for inflation, based on available data.
The bank has stressed that it remains committed to evaluating new data as they become available, and to considering possible second-round effects in its decision-making. But based on the data we have now, we think the way would be clear for the ECB to cut first.
Monetary-policy transmission remains effective, evidenced by tighter credit conditions and slower credit growth. Headline inflation has fallen significantly in 2023 and continues to decline faster than expected. And though core inflation—specifically services inflation—remains slightly more stubborn, it’s slowly following a similar downward path despite strong wage pressures.
Furthermore, the ECB’s March forecast and projections showed further falls in inflation ahead: headline inflation is expected to be 2.0% in 2025 and 1.9% in 2026. Essentially, inflation is already at target in the medium term, and further downward revisions are more than likely in June.
On the hawkish side, some members of the ECB governing council remain preoccupied by wage increases. But we think the data will allay their fears: wage growth slowed slightly in the fourth quarter of 2023 and is expected to ease further in 2024 (Display).
Therefore, we believe all the necessary macroeconomic conditions will be met in the next few months for the ECB to start cutting rates in June.
