The ECB’s precautionary first cut

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Almost two years after its interest rate-raising cycle began, the European Central Bank made its first cut on Thursday. The quarter-point drop from 4 to 3.75 per cent, which president Christine Lagarde had teed up in recent months, will give European borrowers some relief. The ECB followed through with what it had indicated, which matters for the credibility of the institution. It also made a pragmatic, precautionary move.

Central banking is about weighing up risks. Since the pandemic, the fear has been that rising inflation would spiral higher if rates were not restrictive enough. Slowly, the dynamics have shifted. Now, with inflation trending down and inching closer to 2 per cent across advanced economies, the impact of the high cost of credit on economic activity is receiving more attention. Keep rates too high, for too long, and inflation may fall too far — and take growth with it.

In the Eurozone, inflation has been gliding gently down towards 2 per cent all year, with a slight hiccup last month. Forward-looking indicators appear promising. Surveys of business sales price expectations point to a weakening in core inflation components ahead, as do falling wages advertised on postings tracked by Indeed, a jobs board.

Signs that the disinflation trend will continue, combined with 18 months of weak quarterly economic growth, are a decent enough rationale to remove the top level of rate restriction. Although recent indicators look more optimistic for activity, tight lending conditions and declining hiring plans suggest it remains restrained.

Lagarde was still wise to be tight-lipped about the ECB’s subsequent moves. The uptick in Eurozone inflation in May combined with continued global economic uncertainty — including over supply chains and tariff regimes — underline that there are still upside risks to prices. Accordingly, today’s 25 basis point cut, which keeps the ECB’s policy relatively restrictive, should be seen as a calibrated step to weaken the vice on the Eurozone economy, and not the beginning of a quick-fire easing cycle.

Central banks in advanced economies are increasingly aware that waiting until inflation reaches 2 per cent before cutting rates may be too late. On Wednesday, the Bank of Canada made its first cut. The US Federal Reserve and Bank of England will need to make their own risk assessments at their meetings in the coming weeks, too.

Until recently, sturdy economic growth and a stop-start disinflation process had raised prospects that the Fed would delay rate cuts further into the year. But a run of data, including a downbeat manufacturing outlook, more signs of cooling in the jobs market and a resumption of the downward trend in core inflation in April — albeit still too high above target — has emboldened doves calling for a precautionary first cut. The latest non-farm payrolls data, which land on Friday, will provide a clearer picture.

In Britain, inflation took a mighty leap down to just 2.3 per cent in April, yet rates remain at their peak this cycle. Unemployment has been edging up and hiring activity is weakening, although hawks point to some risks of stickiness in prices.

After numerous months of overshooting their inflation targets, monetary policy makers are understandably worried that price growth may swing back up again. But they must also be alert to the changing balance of risks, as they trade off inflation and growth. Other central banks might judge that they do not need to copy the ECB’s move immediately, but they are unlikely to be far off.

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