Is a very strong Yankee economy the last stop for interest rate cuts?

Published

21.05.2024

Author of the book
Municipal Finance

Inflation in the euro area has fallen faster than anyone expected since last summer. This development must have been a very positive surprise for the European Central Bank as well.

However, in its own rhetoric, the ECB has continued to try to curb the market’s interest rate cut expectations by outlining the risks that could lead to a rebound in inflation. Unrest in the Middle East creates permanent uncertainty in energy price trends, and the current Red Sea conflict is particularly pushing up commodity prices. However, the Fed can’t really do anything about these geopolitical risks.

Rivaka’s salary increase is a very difficult issue. The ECB has been diligent in reminding us that while firms may not be able to fully pass on the increase in wage costs to consumer prices now due to weak demand, the situation could change once the economy recovers. This argument has a bit of a dignified flavor. In the past two months, indicators of the euro area’s sentiment side have picked up slightly, but they still do not point to a significant growth in demand.

The ECB’s reasons for caution are certainly understandable. Restoring price stability is the central bank’s most important task, and lowering the market’s interest rate expectations too far ahead could jeopardize achieving that goal. In any case, obstacles to easing monetary policy are being removed at a good pace. In retrospect, a significant break in inflation seems to have already happened last spring: since April 2023, consumer prices in the euro area have risen by only 0.4% and core prices by 0.2%. Given a thorough assessment of the fundamentals of the euro economy, it would seem realistic to expect the ECB to begin cutting interest rates in June, and to expect key interest rates to be roughly one percentage point lower than they were by the end of the year. Now.

“However, obstacles to easing monetary policy are being removed at a good pace.”

However, the US economy, with growth and employment exceeding expectations, remains disconcertingly strong. Usually, the US central bank, the Fed, is the first to make monetary policy changes, followed by the ECB slightly later. This time, the same wind protection may not be available.

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The central bank already has time to signal interest rate cuts more clearly than the ECB, but the inflation situation in the US is more volatile than in the euro area, and there is still no clear penetration of rising consumer prices. The Fed may not cut rates until the second half of the year.

In the spring, the ECB will consider the extent to which US aid could accelerate the euro area’s recovery and increase risks of demand-driven inflation. Or, what happens to the value of the euro and import inflation if the interest rate differential with the US starts to widen, along with interest rate cuts.

“Current interest rates are too high in view of the euro area’s growth potential and large investment needs.”

On the other hand, since monetary policy changes affect the economy with a delay, there is no reason to unnecessarily postpone the start of interest rate cuts. Current interest rates are too high given the euro area’s growth potential and large investment needs. In addition, known vulnerabilities in interest-sensitive sectors of the economy, particularly the real estate market, may increase and threaten the stability of financial markets. The first signs of this have already been seen in the United States.

The author holds a PhD in Political Science with a thesis in Economics and is the Chief Economist of Municipal Finance. You can also find Timo Vesala’s message board From X!

Municipal Finance

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