Christine Lagarde once described the fight against inflation as an “art”. The President of the European Central Bank and her Council colleagues will find out in the coming months whether they were overly artistic with the decision to initiate the downward turnaround in interest rates. On Thursday, the central bank cut key interest rates for the first time since 2019, by 0.25 percentage points. The main refinancing rate, at which banks can obtain fresh money from the central bank, is now 4.25 percent. The deposit rate is 3.75 percent. The central bank considers it to be the most important control instrument because it pays interest on the banks’ excess reserves.
The decision came as no surprise, as the ECB has been preparing the public for this decision for months. Lagarde’s team follows the central banks in Canada, Switzerland and Sweden, which have already cut interest rates. The US Federal Reserve and the Bank of England, on the other hand, are still waiting.
A cut in key interest rates is often seen as a signal that inflation has been defeated. But it has not. In May, inflation in the euro zone rose again after a long period, to 2.6 percent. In the two months before, the figure was 2.4 percent. This is of course progress compared to the inflation rate of more than ten percent in autumn 2022. But the ECB is aiming for an inflation rate of exactly two percent for the 20-country community, and it could be difficult to reach this target quickly.
The unemployment rate in the euro zone is at 6.4 percent, the lowest ever
There are many reasons for the rising prices: Inflation is still persistent in the service sector, which is painfully noticeable for restaurant visitors, for example. The decent wage growth in Germany and other countries in the monetary union was also unexpectedly strong in the first quarter, with companies often passing on the additional costs directly to product prices. Trade unions are using their strong negotiating position, as the unemployment rate in the euro zone is at an all-time low of 6.4 percent.
It is therefore still unclear whether Lagarde will soon follow the first interest rate cut with a second and third. ECB Council member and Bundesbank President Joachim Nagel stressed that one cannot derive a “kind of autopilot” from a first interest rate cut that would immediately lead to the next interest rate cut. Nothing should be rushed. ECB chief economist Philip Lane said in an interview with the Financial Times that the ECB’s monetary policy must remain “restrictive throughout the year” despite foreseeable easing. For governments and households, this means that key interest rates could fall a little more – but the low interest rates of the 2010s are not in sight.
“This week’s interest rate cut will probably prove to be a mistake in retrospect”
In July 2022, the ECB ended its years-long policy of zero and negative interest rates in order to get a grip on inflation, which the central bank had initially underestimated and which eventually rose to record levels. The central bank raised interest rates ten times in a row before taking a break from September 2023. Until Thursday, the main refinancing rate was 4.5 percent, the highest it had been in August 2001. During this phase of interest rate hikes, the deposit rate reached four percent, the highest level since the monetary union was founded in 1999.
“In retrospect, the interest rate cut this week will probably prove to be a mistake,” says Jörg Krämer, chief economist at Commerzbank. Consumer prices – excluding the volatile prices of energy and food – have risen sharply since the beginning of the year. In addition, according to Krämer, a downward trend in collective wage increases is not yet apparent.