Why should ECB worry about growth and not inflation?
Cutting rates? That was the easy part. As widely expected, the European Central Bank on Thursday lowered borrowing costs for the first time in nearly five years, bringing the benchmark deposit rate from 4% to 3.75%.
The path forward is murkier. The ECB says inflation is receding, but slowly. That will allow Frankfurt hardliners to argue further cuts should be delayed. But putting the foot on the brake now would hurt the euro zone’s nascent recovery.
ECB President Christine Lagarde likes to say the central bank is “data-dependent”, meaning that it analyses and reacts to what incoming economic numbers show, instead of following a predetermined course. Her problem is that the data is not cooperating. In May, headline inflation rose at an annual rate of 2.6%, up from 2.4% in April, official figures show, moving away from the ECB’s 2% goal. Services inflation, a big concern for policymakers, jumped to 4.1%, the fastest pace since last October. And wages are also rising faster than Frankfurt would like. Meanwhile, the bloc’s economy is picking up pace. After five quarters of stagnation, GDP grew at 0.4% year-on-year in the first three months of 2024.
Lagarde and her colleagues deserve to take a bow: they have managed to bring inflation down from 10.6% in October 2022 without shattering the euro zone economy, barring a short recession at the end of last year.
The challenge for the ECB will be to start seeing through the data, not least because they will be skewed by one-off factors. That means continuing to cut rates at a steady pace even before inflation hits the target, which won’t happen before 2026, according to its staff’s forecast. The risk is, of course, that prices remain stubbornly elevated or that looser monetary policy pushes them even higher.
There is a bigger danger: by keeping rates high even as inflation falls from 2.5% this year to 2.2% in 2025 and to 1.9% in 2026, as per ECB forecasts, Lagarde could choke off the nascent pick-up in euro zone economic activity. At present, business confidence is at a 27-month high, while inflationary pressures are cooling, according to a survey of around 5,000 companies by S&P Global.
Keeping borrowing costs elevated would dent confidence and reduce firms’ ability to borrow to fund investment, trade and employment. With the United States’ economy set to expand by 2.7% this year, compared with just 0.9% for the euro zone, Lagarde cannot afford to wait for benign data to boost growth.
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