The European Central Bank cut interest rates for the first time in nearly five years on Thursday, signaling a shift away from its aggressive policy to stem a rise in inflation.
As inflation hit the bank’s 2 percent target, officials cut the three main interest rates applicable in all 20 countries that use the euro by a quarter-point. The benchmark deposit rate was cut from 4 per cent to 3.75 per cent, the highest in the bank’s 26-year history, the rate was fixed from September.
“The inflation outlook has improved significantly,” ECB President Christine Lagarde told a press conference in Frankfurt on Thursday. “It is now appropriate to moderate the level of monetary policy restraint.”
But he gave no strong indication of how often or how soon the bank might cut rates again.
There is growing evidence around the world that policy makers believe that high interest rates are effective in controlling economies to reduce inflation. Now, they are lowering rates, which will provide some relief by making loans cheaper for businesses and households.
On Wednesday, the Bank of Canada became the first group of 7 central banks to cut rates. Central banks in Switzerland and Sweden also recently cut interest rates.
There is greater reluctance to ease policy in the United States, where Federal Reserve officials are more optimistic about the end of recent stubborn inflation readings. The Bank of England has opened the door to interest rate cuts, which some officials have said could come this summer.
The ECB’s rate cut on Thursday, the first since September 2019, sends a strong signal that the worst of Europe’s inflationary crisis is firmly in the rearview mirror. By late 2022, average inflation across the eurozone rose above 10 percent as energy prices surged through consumer goods and services, and workers demanded higher wages to dull the pain of rising prices.
In recent years, the ECB has embarked on a more aggressive cycle of rate hikes. Policymakers have raised the deposit rate, which banks receive for overnight deposits with the central bank, from negative 0.5 percent in July 2022 to 4 percent in September.
This helped reduce inflation in the eurozone to 2.6 percent in May. For much of the past year, lower energy prices have helped keep inflation down. Food inflation has eased to below 3 percent from 12 percent a year ago.
“Monetary policy controls financial conditions,” Ms Lagarde said. “It has made an important contribution to bringing inflation back down by reducing demand and keeping inflation expectations well-positioned.”
On Thursday, Europe’s key stock index hit a record high before the rate cut was announced, but erased some of its gains amid signs the bank is wary of future rate cuts.
The central bank warned there were still signs of strong price pressures, meaning inflation would remain above the 2 percent target “well into next year”. Headline inflation is forecast to average 2.2 percent next year, above the bank’s forecast three months ago.
The latest inflation data was stronger than expected. Services inflation, which was particularly stubborn, rose to 4.1 percent in May from 3.7 percent in the previous month. Policymakers are closely watching wage growth, which could push up consumer prices if companies pass on higher wage costs instead of absorbing them.
“Wage growth has picked up,” Ms Lagarde said, although it was forecast to moderate for the rest of the year.
He added that he did not describe the central bank as still in a “dial-back phase”. Instead, policymakers need to “continue to make sure we’re on this inflationary path” every time they meet, using new economic data to set interest rates.
Traders have trimmed their bets on more rate cuts this year, leaving the probability of cuts in September and December equally likely.
“This is not a central bank in a rush to ease policy,” Mark Wall, chief European economist at Deutsche Bank, said in a statement.
Officials face a challenging balancing act. On the one hand, policymakers want to cut interest rates at the right time to avoid causing excessive damage to the economy, which could push inflation below their target. On the other hand, they don’t want to ease policy too soon, which could lead to a revival of inflationary pressures.
Investors looked to the U.S., where inflation has proved stickier than initially expected, and wondered whether what’s happening in Europe should be taken as a warning about what might come next.
There is also doubt about how far the ECB can cut rates while the central bank waits. Higher interest rates in the United States would tighten financial conditions there and in other countries due to the global role of the dollar, which would weaken the euro and risk importing inflation.
After more than a year of economic stagnation, the region’s economy is showing some signs of recovery, further justifying the ECB’s cautious approach. On Thursday, the bank’s staff forecast the eurozone economy would grow by 0.9 percent this year, down from a forecast of 0.6 percent three months ago.
The services sector is expanding, the manufacturing sector is stabilizing at a lower level and exports are expected to grow as global demand picks up, Ms Lagarde said. At the same time, the combination of lower inflation and higher wages will improve the spending power of consumers. He added that monetary policy will also reduce the drag on the economy as rates fall.
However, Ms. Lagarde highlighted the uncertainty in the inflation outlook, noting that price growth will fluctuate around its current level throughout the year and that there will be “bumps in the road”. Rate decisions will be made based on incoming data at each meeting.
“We are not committed to a specific rate path,” he said.
