MNI SOURCES: Fed, Geopolitics, Feed ECB Caution Over Cuts
Some officials fear the scope for ECB rate cuts may be restricted by external factors.
The diminishing prospects for Federal Reserve easing this year are adding to broader concerns about geopolitical risks to prices to feed European Central Bank caution about the path of monetary policy, with some Eurosystem officials telling MNI that the scope for rate cuts past June may already have been somewhat reduced.
One official who recently anticipated 75-100 basis points in deposit rate cuts this year has shifted to a range of 50-75bp. All sources agreed with consensus expectations for the cycle’s clearly-signalled first rate reduction, by 25bp to 3.75%, at the ECB’s next meeting on June 6.
“If the Fed does not cut, we have to cut less,” said the source, though he cautioned that uncertainty over U.S. rates was high. “The Fed not moving or moving later means that we can see more imported inflation based on our inflation differential.”
Still, the Fed is a “second-order” problem compared to the broader risks presented by geopolitics, with the Middle East in conflict, war in Ukraine and tensions rising between the West and China.
“The problem is energy prices and geopolitical tensions. These factors, that seem to be sleeping, can really change the big picture and we can’t predict it,” the official said.
NOT FED-DEPENDENT
While President Christine Lagarde stresses that the ECB is “data-dependent and not Fed-dependent,” most officials acknowledge that a “significant divergence” with U.S. rates would be problematic. Some insist that less Fed easing would sap demand and call for the ECB to cut by more than the 100 basis points they have until now thought appropriate, with Italian central bank Governor Fabio Panetta noting that “high U.S. rates would reinforce the case for a rate cut,” but others such as Austria’s Robert Holzmann argue the opposite, with several officials telling MNI they fell into the latter camp. (See MNI SOURCES: ECB Wary Of Any "Significant Divergence" With Fed)
Tighter Fed policy affects the eurozone both via the exchange rate, with a potentially weaker euro feeding inflation, and also by raising longer-term bond yields, with a dampening effect on borrowing and activity, another source noted.
“If I had to make a bet, I would say that over the horizon that matters for inflation targeting, two-to-three years, the exchange rate effect, if large enough, would dominate and worsen the eurozone inflation outlook, leading the ECB to cut less and, or, more slowly,” the source said.
Rates markets have pared back expectations for ECB cuts, with just over 70 basis points priced in by the December meeting. An official from a national central bank near the centre of the debate noted this was in line with ECB projections, in which it has regained confidence following Covid pandemic surprises.
“The projections show inflation at or below target from mid-2025 and that is on the assumed rate path for the March round. On that basis, there is no reason to assume the path will be much divergent from that,” the official said.
RESTRICTIVE STANCE
A source at a different central bank, who still expects 75bp of cuts with an outside chance of 100, noted that easing from current rate levels would not be inflationary.
“At present, we think we can gradually take 75bp away and still be in restrictive territory. This time next year, we may be able to go further in removing that barrier, but we will not know until we are there.”
Still, greater uncertainty surrounding the Fed and geopolitics will cloud decision-making for the ECB, keeping it tied to data-dependence beyond June rather than being able to provide clearer guidance. Sweden’s central bank chief told MNI recently that doubts over both Fed and ECB cuts made his own easing path harder to guarantee. (See MNI INTERVIEW: Fed, ECB Cloud Riksbank Easing Outlook- Thedeen)
“The Fed moving later means that we have to be more careful,” another source said, dismissing arguments in favour of more ECB cuts in response to higher-for-longer U.S. rates.
GEOPOLITICS
Another official, though, said the foreign exchange reaction to the shift in U.S. rate expectations could be limited, perhaps just a few cents, and minimal in comparison with sharp moves such as those seen in 2015 when the ECB started quantitative easing. Officials still see geopolitical tensions and the danger of price spikes for oil or natural gas as the main possible barrier to disinflation.
“If it weren’t for rising risks of this sort, it would be easier to define a rate path that at the moment seems difficult for us to have beyond the June indication,” a dovish source said. “Hence this apparent contradiction occurs between being data dependent and at the same time feeling comfortable with market pricing.” (See MNI SOURCES: ECB Still Divided Over Guidance As It Nears Cuts)
The first source was also concerned.
“The risk would be that if we start cutting and because of these factors we have to dial back because inflation jumps again.”
An ECB spokesperson declined to comment.