ECB Monetary Policy Decision Preview: A Post-Summer Balancing Act

Summary:

• Expect a 25bps rate cut, but don’t hold your breath for any clear forward guidance. The ECB will remain data-dependent, monitoring core inflation closely.
• Bond markets may be pricing in 65bps of cuts by year-end, but that’s a bit too optimistic. We expect two cuts: one in September and one in December, as core inflation pressures remain too strong for a more aggressive rate-cutting cycle.
• Core inflation is likely to be revised upward, while headline inflation, growth and wage growth are expected to be revised downward enabling the ECB to deliver another rate cut.

ECB set for cautious rate cuts, but no aggressive easing as core inflation remains persistent

As ECB policymakers return from their summer break, they’re diving headfirst into the task of managing an economy where inflation remains sticky and growth is not keeping up with expectations. With a major monetary policy decision coming on Thursday, September 12, expectations are baked in for a 25 basis point rate cut. But the bigger question is—what happens after that?

1. Inflation: Core Pressures Still Persist

• Services Inflation: Still Sticky
  The ECB had hoped that inflation would cool down more over the summer, but services inflation has been stubbornly high, rebounding to 4.2% in August. While it was expected to rise slightly due to seasonal effects, the fact that services prices have been hovering around 4% since November 2023 shows this isn’t just a temporary blip. Even after a brief dip to 3.7% in April, inflation in the services sector quickly rebounded.
• Headline Inflation: Easing, But Don’t Get Too Excited
  Headline inflation looks much better on the surface, having dropped from 2.9% in January to 2.2% in August, largely driven by easing in food and energy prices. However, core inflation, which excludes those volatile items, has been a different story, stabilizing above 2.5% since April and hitting 2.8% in August. This core figure is key for the ECB, as it reflects the broader, more persistent inflationary pressures in the economy.

2. Wages Growth Slowing, But Still Elevated

Core inflation’s stickiness can be partially explained by sustained wage pressures. Negotiated wages were 3.6% in Q2 2024, down from a high of 4.75% in Q1 but still well above the pre-pandemic average of 1.73%. This cooling in wage growth is a relief for the ECB, but not enough to suggest that wage-driven inflation is going away anytime soon. Additionally, the Eurostat Labor Cost Index (20 countries) also dropped from 4.9% to 4.1% in the same period, providing further signs that wage pressures are easing, albeit slowly. This gradual reduction in wage pressures will likely ease inflation concerns over the medium term, but it's unlikely to lead the ECB into an aggressive rate-cutting cycle, as some in the market are hoping.

3. Macroeconomic Projections: Expect Some Revisions

At this meeting, the ECB will also update its macroeconomic forecasts. Here’s what we expect:

• Headline Inflation Revision: The ECB's previous forecast for Q3 headline inflation was 2.3%, but with energy prices easing more than expected, the actual data should come in lower. As a result, we expect the ECB to revise its headline inflation forecast down slightly from 2.5% to 2.4% for 2024.
• Core Inflation Revision: With core inflation proving stickier than expected, the ECB is likely to revise its core inflation forecast upward from 2.8% to 2.9% for 2024. Services inflation, in particular, continues to be a thorn in the ECB’s side, and such upward revision will reflect that.
• Wages and Compensation: The ECB's June forecast for compensation per employee was 5.1% YoY, but actual data came today at 4.3%. This downward revision in wage growth will help ease inflationary pressure over time, particularly in services, but it's unlikely to shift the ECB's outlook drastically for the remainder of the year.
• Growth: A Softer Outlook Ahead. In the upcoming projections, the ECB is expected to revise its Q2 GDP growth forecast down from 0.4% to 0.2%, based on final data. The ECB currently predicts 0.9% growth for 2024, but market analysts are more cautious, expecting only 0.7%. A downward revision in growth would lessen the pressure on core inflation, potentially giving the ECB a bit more breathing room.

4. What’s Next for Interest Rates?

• 25bps Rate Cut Likely on September 12
  The market is widely expecting a 25 basis point cut at Thursday’s meeting, and we think the ECB will deliver. However, don’t expect the ECB to provide any clear forward guidance on what happens next. Policymakers are likely to remain data-dependent, monitoring the inflation and growth outlook closely before making further moves.
• Market Expectations: 65bps by Year-End Looks Optimistic
  Bond markets are currently pricing in 65 basis points in rate cuts by the end of the year, but we think that’s overly optimistic. While inflation is easing, core inflation pressures are still too persistent for the ECB to engage in a deep rate-cutting cycle. Our base case is for two cuts: one in September and another in December. After that, unless inflation drops off significantly, it’s hard to see the ECB cutting rates aggressively.