MNI SOURCES: ECB Neutral Rate Debate Heats Up As Growth Weak

MNI (LONDON) - Discussions over the neutral level of interest rates will soon intensify within the European Central Bank’s Governing Council, which is likely to make at least two further 25-basis-point cuts this year, taking it towards the lower end of restrictive policy as the economy slows, Eurosystem officials told MNI.

While one source said financial market volatility earlier this month following a Bank of Japan rate rise and weak U.S. jobs data further signalled the need to ease policy, the official conceded that the ECB remained on its expected course, with a baseline expectation for two 25-basis-point cuts to take the deposit rate to 3.25% in December. Other officials downplayed the significance of the short-lived risk selloff, with one calling it a market-driven move exacerbated by thin summer volumes.

As the ECB eases and inflation falls back, the point approaches where policy ceases to be restrictive, though where this lies is subject to debate, officials noted. Market pricing currently implies about 68 basis points of easing by December, with plunging sentiment indicators in Germany as the eurozone’s largest economy fails to enter recovery boosting the implied probability of a cut in October, and a total 143bp of easing by next July.

“I think the Governing Council agrees that until we get to rates at 3% we are in restrictive territory. But beyond that everything turns more blurry, because it depends on the natural interest rate,” one said. “I expect that we will start discussing hard on r-star at the end of this year as a way to lay the ground for what to expect in 2025.”

R-STAR

But another source said that the talk about r-star showed how recent market volatility was being taken by some as justification for immediately trying to determine how low rates can be taken.

“Overall, I remain shocked by the amount of time day-to-day mood swings in the markets immediately trigger in terms of speculations over r-star and other long-term structural factors. Have people forgotten that the central bank mandate is not about asset prices?” the source said. “Greenspan messed up a lot of things back in the day.”

While the use of r-star, an academic term for the real neutral level of interest rates, is contentious, another official agreed that debate on neutral is set to intensify, even as the ECB remains focussed on economic data. (See MNI INTERVIEW: Vital ECB Returns Inflation To 2% By 2025 - Wunsch)

“Will we discuss where and when policy shifts from restrictive to neutral to accommodative? Of course, it will continue be at the heart of our discission and the closer we get to terminal the deeper the talks. But framing it in terms of academic r-star is wrong and as unhelpful as when we were tightening,” the source said.

“We will continue to monitor metrics for the shift as we have in recent months - data like consumer and corporate borrowing, confidence levels etcetera.”

PROJECTIONS

ECB President Christine Lagarde was circumspect when asked about estimates of neutral following June’s 25-basis-point rate cut. While the neutral rate has increased since its pre-pandemic levels, it was still far away with the deposit rate at 3.75%, she said.

The ECB’s quarterly economic projections have regained prominence in policy setting following post-pandemic dislocations, with June’s edition only predicting anaemic growth, of 0.9% this year and 1.4% in 2025, as inflation returns to the 2% target by the fourth quarter of next year. A large downgrade to next year’s growth outlook in September’s edition would favour the argument for easing, one official said.

A recent ECB paper, while not expressing an official ECB opinion, cited a median estimate of the natural real rate of interest near zero, but the source noted that some saw it as high as 1%, and that more precision would be necessary as the easing cycle progressed. (See MNI: Market Measures Of r* Steadier In Pandemic-ECB Economists)

But one of the sources stressed that while the level of neutral is highly uncertain, it is not necessarily a bad thing that the eurozone economy is now feeling the brunt of past tightening.

“I never believed in immaculate disinflations,” the source said. “The only way to kill the beast is to get the economy to slow down.”

An ECB spokesperson declined to comment.