The European Central Bank reduced its policy rate by 25 basis points on Thursday which, following the 25 basis-point rate reduction by the Bank of Canada on Wednesday, represents the first in what we expect will be a series of rate cuts by the G7 central banks this year.
The moves in Europe and Canada are likely to be followed by the Bank of England in August and the Fed this fall and mark the start of a period of gradual loosening monetary policy across the G7 that will last through next year.
Read the global forecast for interest rates in RSM’s latest issue of The Real Economy.
Thursday’s rate cut was well telegraphed and fully priced in by markets so there were no surprises.
The recent inflation and wage data have proved to be a little hotter than anticipated, muddying the water for the immediate outlook. Indeed, the ECB will probably pause in July. But the big picture is with inflation now close to the central bank’s target and growth still extremely weak, further cuts this year and next are on the way.
We anticipate a three more quarter-point rate cuts this year from the ECB in September, October and December bringing its policy rate down to 3.5% by the end of the year.
That move is dependent upon further disinflation in the euro zone and an easing of wage pressures. Our estimation of the ECB’s reaction function, measured by our Taylor Rule estimate, implies that the optimal rate lies in a range between 3.75% and 4%.
For purposes of transparency, we have set the neutral rate at 1% and the non-accelerating inflation rate of unemployment at 6%. This implies an optimal policy rate at the current time of 3.95%.
Current market pricing suggests that there is a 68.2% probability of a rate cut in September, 25.7% in October and 58.2% in December. The risks around our call for aggressive easing of the policy rate by the ECB revolves around the direction of further disinflation through the end of the year. Inflation currently sits at 2.6% on a year ago basis.
Admittedly, policy divergence between the major central banks carries with it a risk of currency volatility over the next few months. Indeed, this is the first time that the ECB has cut before the Fed.
But that risk is acceptable and even necessary given the radically differing economic situations in the euro zone and UK compared to the US. What’s more, currency volatility should be limited if, as we expect, the Bank of England cuts interest rates in August and the Fed not long after that.
In total, we are expecting three further rate cuts in Europe, three in the UK and two in U.S., which mainly reflects the relative strength and weakness of these three major economies.
