ECB to cut rates again as economic outlook sours

The European Central Bank is set to cut interest rates on Thursday as souring economic prospects force it to abandon an approach that many of its top brass now see as too cautious.
Financial markets have now almost fully priced in a quarter-point rate cut on Oct. 17 followed by a similar move at the ECB’s December rate meeting. This would take the key deposit rate to 3 percent by year end from the current 3.5 percent.
A surprisingly sharp drop in inflation in September, and downward revisions to this year’s growth forecasts in Germany and elsewhere “will convince governors of the need for an October cut, especially as the ECB could otherwise be forced to take bigger action in December,” said Société Générale economist Anatoli Annenkov.
Dismal results from a survey of around 5,000 companies — the so-called composite PMIs — have particularly spooked investors and policymakers, by suggesting that activity had contracted for the first time since February now that the sugar rush to consumption from the Paris Olympic Games had faded. With the U.S. slowing and China’s economy still struggling with a chronic real estate crisis, the odds of a hard landing for the eurozone have risen.
Throw in inflation dropping more than expected, and even traditional hawks such as Latvia’s Mārtiņš Kazāks were ready to agree with “market pricing that the decision in October will be very clear.” Eurostat estimates eurozone inflation fell to a three-year low of 1.8 percent to undershoot the medium-term target of 2 percent.
This may seem like a quick turnaround in response to two single data points, especially since ECB President Christine Lagarde has repeatedly stressed that the central bank looks at a full array of data. Moreover, much of the September drop was due to energy prices that have sharply rebounded this month as conflict has flared up again in the Middle East. Services inflation, at 4.0 percent, has hardly slowed all year, while “core inflation,” excluding food and energy, is still clearly above target at 2.7 percent.
A former rate setter, however, viewed it as a sign of the Governing Council catching up after failing to change its risk assessment to the economic outlook over the summer, even as it become clear that things in the eurozone were heading south. “The risk assessment had not changed at all between July and September, which to me was very surprising,” he said, granted anonymity to speak candidly about former colleagues.
Bank J. Safra Sarasin economist Karsten Junius warned that the ECB may not only have been behind the curve in fighting the inflation surge that started in 2021, but might also have been better off stopping rate hikes and/or starting cuts earlier.
At least three policymakers have publicly warned that inflation is now at risk of undershooting the target. Even before the dismal data prompted a rethink on the Governing Council, Mario Centeno told POLITICO that the ECB really has “to minimize the risk of undershooting, because that’s the main risk.”
His Greek counterpart, Yannis Stournaras, another policy dove, and Bank of France Governor François Villeroy de Galhau have made similar warnings in recent days that the ECB risks undershooting the inflation target and bringing back the old problem of too little inflation.
That may seem far-fetched to some, given the differences in circumstances from the decade that followed the financial crisis. As many ECB officials themselves have argued, the decade-long struggle with “low-flation” was caused largely by a sovereign-debt crisis that also crippled the ability of banks to supply credit. Despite some fears about budget consolidation, that is far from being the case today.
But the fear of going there again is visceral. To address the risk of deflation a decade ago, the ECB had to embrace hugely controversial measures such as massive discretionary bond purchases that tested the limits of the EU Treaty, as well as negative interest rates that hurt the banking sector and tens of millions of European savers. They also left the central bank with massive losses and bloated balance sheets for years to come.
Yet despite a worsening balance of risks, the ECB is still unlikely to opt for bolder action — or “front-loading” in central banking lingo. The U.S. Federal Reserve’s surprisingly strong half-point cut last month, which might have been a signal for more rapid easing around the world, now seems less emphatic after a succession of U.S. data pointing to a soft landing rather than a recession. The minutes from that meeting, published on Wednesday, made clear that there was significantly more resistance to that move than initially seemed the case.
Stournaras and Villeroy de Galhau have both played down the chance of a “jumbo” cut.  “We have to act gradually,” Stournaras told France Info on Wednesday. “We are used to acting with gradualism, which means resolutely but without making too significant steps,” Villeroy de Galhau seconded. 
Instead, some analysts expect the ECB to at least signal more confidence about its space to easing further. Having stressed for the last couple of years that it would take things meeting-by-meeting approach and keep policy restrictive, it will now suggest “highlighting that rates will stay restrictive for now to one that suggests “a return to a more neutral level,” predicted RBC Capital Markets global macro strategist Peter Schaffrik.