MNI INTERVIEW: ECB Heading For Spring Cuts-Ex ECB Economist

The eurozone economy is likely to avoid recession, but inflation should slow sufficiently for the European Central Bank to reduce its benchmark deposit rate by around 150 basis points this year, former ECB economist Riccardo Trezzi told MNI.

Markets are moving rapidly to price in cuts, noted Trezzi, who said that while January’s Governing Council meeting should produce little change the possibility of downward surprises to inflation meant that cuts could begin to be considered by as early as March. (See MNI INTERVIEW: ECB Could Discuss Cut Timing In Jan-Centeno)

“When markets understand that something has changed, in this case for the good, they always go ahead of the curve and try to anticipate because it’s the way you make money,” said Trezzi, who worked on the Federal Reserve Board’s inflation desk before taking on a similar role at the ECB.

But while the ECB is likely to successfully avoid “the inflation disaster risks that was really a possibility in 2021 and 2022,” it needs statistical confirmation that 2% inflation is in sight before it can begin to ease, he told MNI’s Fedspeak podcast. Core inflation must fall below 3% and forecasts converge on its target, he said. (See MNI SOURCES: ECB Needs Sub-3% Core Inflation To Consider Cuts)

“We are not too far away. Probably need a few more months of data,” he said, adding that roughly 150 basis points of cuts would bring rates “back to neutral but not below.”

HIGHER NEUTRAL RATE

The real neutral rate of interest at which the economy is in equilibrium in the long run may have risen since the Covid pandemic, he said, adding that it might now be between 0.5% and 1% in the euro area and around 1.5% in the U.S.

But eurozone household finances remain robust, and while a very minor recession is possible, the main scenario is for “a low growth environment like the one in 2023,” Trezzi said. Pandemic-era changes to the economy may have generated false recessionary signals, he went on, pointing to the disconnect between strong labour markets and weaker GDP data.

“Covid was an incredible shock and generated lots of misallocation across the sectors, so maybe the signals that you get in one sector are more than compensated in other sectors,” he said, adding that purchasing manager’s indices may now not indicate recession until they have fallen below the usual threshold of 50 to as low as 48.

The recent slow-down in hirings is normal after more than two record-breaking years for the labour market, with workers in short supply in much of the eurozone, according to Trezzi.

“We are missing workers everywhere at what you look at. Demographic trends are kicking in. Covid was an acceleration of demographic trends,” he said.

This labour market tightness could mean that eurozone GDP was underestimated in 2022 and 2023, he added, though he noted that workers have still not regained loss purchasing power.