September ECB meeting preview: Easy does it

Following July’s pause, the ECB is widely seen resuming its easing path this week. Falling inflation, a strengthening euro and an expected Federal Reserve rate cut next week provide all the scope needed while a still very sluggish economy offers plenty of justification. Although there may be some reluctance on the part of the hawks, most Governing Council (GC) members are likely to favour a second 25 basis point cut that would put the key deposit rate at 3.50 percent. However, the central bank is also likely to repeat the recent limited forward guidance whereby it “will keep policy rates sufficiently restrictive for as long as necessary” to achieve the inflation target. It remains data-dependent.

Note too that back in March, the bank indicated that it wanted to narrow the refi rate-deposit rate spread (50 basis points since September 2019) to just 15 basis points by 18 September. This would be undertaken with a view to incentivising bidding in its weekly operations so that short-term money market rates remain close to the deposit rate. If this aim still holds, a 25 basis point reduction in the deposit rate would point to a larger 60 basis point cut in the refi rate to 3.65 percent.

Meantime, QT continues to act as a partial offset to interest rate cuts. Now incorporating the €1.7 trillion pandemic emergency purchase programme (PEPP), overall net asset sales in July/August were some €59.7 billion. Of this, €15.0 billion came from the PEPP, in line with its €7.5 billion average monthly target through December. This implies a significant additional withdrawal of liquidity compared with the period when QT simply encompassed the asset purchase programme (APP).

Financial markets have become even more convinced about rate cuts over coming months and quarters. At 3.0 percent, 3-month money rates in December are now expected to be about 25 basis points below the level priced in just before the July meeting. Indeed, by the end of next year, the gap is still wider at fully 50 basis points with rates now seen only fractionally above 2.0 percent.

Key to this week’s decision will be the updated economic forecasts. In the June edition, headline inflation was put at 1.9 percent and the core rate at 2.0 percent by the end of the projection period. The new predictions will need to show inflation similarly well behaved to accommodate another round of easing. To this end, the chances of a second reduction in key rates were boosted by the flash August inflation report. This showed the headline rate sliding to within a couple of ticks of its target and the narrow core measure easing to its second lowest level since February 2022. Still, the GC hawks will have been less than impressed by an increase in service sector inflation to 4.2 percent, a 10-month high. The spike here may simply reflect a one-off boost from the Paris Olympics but it makes the September data all the more important to future policy decisions.

The ECB will also be casting a wary eye over the latest wage developments. The central bank’s own series currently runs only as far as last quarter but at least showed the yearly rise cooling to 3.6 percent, its lowest mark since the fourth quarter of 2022. However, it was still well above pre-pandemic levels and high enough to remain a threat to the inflation target without an improvement in productivity and/or businesses accepting a squeeze on profit margins. In addition, the latest Indeed wage tracker data have suggested some upside risk for the current quarter.

Either way, with domestic demand having contracted last quarter and total output expanding only very modestly, households and businesses alike would be very happy with another cut in borrowing costs. That said, sluggish second quarter Eurozone GDP growth masked respectable performances by a number of member states, including Spain. The big problem for policymakers is still Germany where earlier hopes that the buds of economic recovery were beginning to appear have proved very premature. In reality, the economy remains in the doldrums, contracting over the first half of 2024 and, as of last quarter, even 0.6 percent smaller than at the start of 2022. German manufacturing output has fallen in four of the last five quarters. Third quarter Eurozone GDP probably got a boost from the Paris Olympics but outside of that, prospects look subdued at best.

Still, by and large, overall economic activity since the July ECB meeting has performed much as expected with upside surprises all but cancelling out downside shocks. In fact, Econoday’s relative performance index (RPI) averaged 6 over the period and currently stands at 8. The mean value for its inflation-adjusted counterpart (RPI-P) is just 1 and its latest reading is only 3 points higher. Accordingly, the broader economic picture provides little fresh ammunition for either the hawks or the doves.

Nonetheless, expectations for another ECB ease on Thursday are certainly strong enough that a decision to hold policy steady would come as a seriously nasty surprise. In itself, this probably increases the likelihood of a move. That said, with inflation in services more than double the target, unemployment at a record low and wage growth still ominously high, the hawks will insist that any cut is accompanied by a warning not to take future easing for granted. Further clear progress on reducing core inflation is an absolute pre-requisite.