ECB cuts now seen in March

ECB View: March to kick-off rate cut cycle - We expect the ECB to cut its policy rates for the first time in March of next year, changing our call for a first reduction which was previously December of this year. This largely reflects the resilience in services inflation and the labour market up until now. However, we continue to expect the ECB to pivot significantly over the next few months, with no further hikes this year and March kicking off a series of rate cuts, taking the deposit rate to 2% by year end.

This is a non-consensus view. Markets do not expect a rate cut until the summer of next year, the consensus of analysts sees the deposit rate peaking at 4% and ending next year at 3.25%. The Governing Council is very clearly signalling a higher for longer policy. So why do our views deviate? 

First, we expect less favourable activity outcomes than projected by the ECB and the consensus. Aggressive ECB rate hikes have led to a powerful tightening of financial and bank lending conditions and are only just starting to bear down on demand. The full-effect of rate hikes on the economy feeds through after 4-5 quarters. Given the timing of the rate hikes, this means we are likely to see major drags on the economy in the second half of this year and first half of next year. 

Second, we think core inflation could come down more significantly over the coming months. We are already seeing aggressive disinflation on the goods side. Non-energy goods inflation was down to 5.5% yoy in June, compared to 6.7% at the start of the year. In addition, with producer prices falling by 3.4% yoy in June, goods disinflation has much further to run. Unfortunately, services inflation has only accelerated over this period (to 5.4% from 4.4%). However, we expect this trend to turn. Services inflation has also been pushed up over the last year or so by higher energy costs and this element of inflation should reverse. Similarly, the post-Covid catch up in restaurant and holiday prices should come off. Against these factors, profit margin expansion and higher labour cost growth are putting upward pressure on services inflation, though the former factors should increasingly offset those, especially as demand weakens.

Third, monetary policy is in deeply restrictive territory. Although there is a lot of uncertainty about the level of the neutral rate, the deposit rate is currently above even the top of the range of neutral rate estimates we track, while it is well above the average of the various estimates (which stands at around 2% in nominal terms). As we move into 2024, with the economy likely having been weak for a year, a clear trend of disinflation in place, and unemployment going up, it would not be unusual for the central bank to start making policy less restrictive. Especially given the lags involved. In addition, as inflation and inflation expectations fall, real interest rates will rise further if the ECB were to keep nominal rates unchanged. 

Balance sheet on auto-pilot - We do not expect the ECB to step up the pace of QT in the coming months, but neither do we expect any reversal. We think that outright sales of securities in the APP are unlikely, given the losses they would generate for the Eurosystem, which is already projected to make losses due to negative net interest income. The only other way to speed up QT is to bring forward the end of reinvestments under the PEPP (currently scheduled to last until end 2024). This is more likely than outright APP sales, but still, the PEPP has been actively used to stabilise peripheral government bonds, so the ECB may want to keep this option open for another year. At the same time, we do not expect the ECB to resume APP reinvestments once it starts to cut rates. With the lower-bound problem for interest rates no longer an issue, we think that interest rate policy and balance sheet policy will be separate. So a gradual decline in the ECB’s securities portfolio looks likely over the coming years in the absence of sever financial shocks.