MNI SOURCES: ECB Needs Sub-3% Core Inflation To Consider Cuts

The European Central Bank will need to see a consistent fall in core inflation below 3% before it considers rate cuts, officials told MNI, with several in broad agreement with market pricing for the first cuts by the end of the first quarter.

“The first thing you have to see is an appropriate projection horizon, and the second is that underlying inflation is going below 3% consistently", one official said, adding that wage increases should remain modest and energy prices and the exchange rate relatively stable.

Another official agreed that 3% core inflation would be a necessary if not sufficient condition for discussing cuts.

“I wouldn't think it's a trigger exactly. Is it fair to say cuts are off the table with core inflation above 3%? Yeah, but it’s not a trigger to open discussions,” the second official said. “If the economy slows, but core is close to but above 3%, albeit trending the right way, discussions may intensify. If core is under 3% but the economy is gathering steam, talks may become less urgent.”

CONDITIONS RIGHT BY Q1

With core eurozone inflation sliding to 3.6% in November from 4.2% the month before, while gross domestic product contracted by 0.1% in the third quarter, the time for talking cuts according to those criteria may be rapidly approaching.

“I think the direction of travel and the core inflation scenario is enough for the subject to be broached seriously in late Q1,” the second official said.

This would be in line with market pricing, which now implies 22 basis points in cuts by March. Investor projections, though, for 129 basis points by October may be excessive, said another Eurosystem official. (See MNI SOURCES: Market Pricing For Cut Prompts ECB Jawboning)

“There is a window in late Q1 for the first cut discussions to perhaps start in earnest, opening up to a cut in Q2. I think 100 basis points in total cuts for next year is a little optimistic, but I certainly see 50 basis points throughout the year and perhaps 75,” the official said.

December’s projections should put inflation at around 2% or perhaps lower for both 2025 and 2026 given the current market rate path, the official said.

An ECB spokesperson declined to comment on the level of core inflation required for discussion of cuts.

Yet upside risks to inflation persist. In addition to the possibility of a surge in energy prices due to geopolitical shocks, fiscal policy may be more expansive than indicated by official data, the first official said, noting that bond issuance data from some countries appeared out of sync with deficit projections. Borrowing could also be pushed higher as revenues receive less of a boost from inflation, the official noted.

“I believe that the economy is going to be stagnant in the next six months. I think the trend of core inflation is downward, but you can have base effects and fiscal policy measures. You can have three months and then surprises and apart from that geopolitical problems,” the official said, stressing that it was hard to say how long rates would remain at current levels but that it was feasible that this would be for two quarters, in line with comments by President Christine Lagarde, or perhaps even three.

But bank lending data is contracting, and models suggest that only about 50% of its effect has yet been felt in the economy, he noted. Signs of economic slowdown were counterbalanced by continuing labour market overheating, he said.

PEPP DISCUSSIONS

A fourth official agreed that a clear declining trend in core inflation would be key for discussing cuts, though stressing that the ECB targeted the headline measure.

“With core, I am not in favor of focusing on specific levels but rather looking for a fast and solid downward trend. Everything seems to indicate that this is likely,” he said. “We can also talk about whether the market curve is compatible with 2% [headline inflation] while maintaining the data-dependent approach. In any case, having the core consistently below 3% tells us a lot.”

Officials who spoke to MNI were also cautious about the timetable for discussing an end to reinvestments under the ECB’s Pandemic Emergency Purchase Programme, despite some calls for the matter to be addressed in December. (See MNI INTERVIEW2: ECB To Discuss PEPP Reinvestment In Dec-Vujcic)

“We haven't talked yet and we will have to talk. Whether it is December, January or February... That will depend on the approach we take,” one source said. “The PEPP is marginal from the point of view of quantity, but the impact on market perception is important.”