Rate cuts are coming in 2024. The ECB lags behind the Fed but March projections will be decisive for a pivot
The Fed has already signalled three rate cuts in 2024. The ECB, instead, remains more concerned about inflation than economic downturn. But recession is getting closer, as the PMI indices also show. The turning point for the ECB could come with the March macro projections
ECB President Christine Lagarde tried on 14 December to counter market expectations of a rapid and significant drop in rates with a more hawkish stance than that of the Fed, despite the fact that the European economy is in a much worse situation than that of the US. But not even 24 hours later came new negative macro data. The Eurozone economy's main leading indicator, the Pmi (Purchasing Managers Index), fell in December to 47, from 47.6 in November, despite analysts expecting the figure to pick up. For the seventh consecutive month, the Pmi index pointed to an economic contraction.
Recession is getting closer but the ECB fears inflation
The prospects of a recession in the Eurozone, after a year of stagnation, have become even more concrete. "The data paint a disheartening picture," noted Hcob who produces the index with S&P Global. "The Eurozone economy shows no signs of recovery. On the contrary, it continues to contract. The probability that the Eurozone is in recession remains very high."
Against this backdrop, one would expect the ECB to be increasingly concerned about the economy. Instead, Lagarde mainly highlighted the risks for inflation, although these are not shared by most economists. On the contrary, analysts are convinced of a higher-than-expected ECB rate drop and are betting on a new estimate revision in March, which could be a prelude to the first rate cut. "I’ll bet the ECB inflation forecast will end up pretty far of reality (unless shock)," noted Erik Nielsen, chief economics advisor at Unicredit. "Either the ECB makes a major U-turn or it will kill any hope of recovery in 2024."
For Citi, inflation in the Eurozone will fall below the ECB target of 2% by the summer of 2024 and will average 1.7% in 2025: the central bank, on the other hand, only sees inflation at 2% from the third quarter of 2025. The Eurosystem's figures were influenced, as in the past, by the Bundesbank's caution on German inflation (still at 2.5% in 2025 and 2.2% in 2026). In Italy, on the other hand, inflation will be below 2% for the entire three-year period 2024-2026, according to Bankitalia. "Where the ECB sees the inflationary pressure coming from remains a mystery to me," Nielsen added, recalling that wages (ECB's main fear) in real terms are below the 2020 level. Moreover, for the economist "running high real rates and CB balance sheet reduction in times of recession is very unusual".
Further balance sheet tightening
The ECB's latest decision went in the direction of further monetary tightening, albeit slight. The reinvestment of securities from the Pepp pandemic plan will be reduced by 7.5 billion per month from mid-2024. Thus the ECB's balance sheet will decline at a faster pace. Lagarde only said it is 'a good moment' to announce the decision, with implicit reference to the fall of the Btp-Bund spread. But she did not give any economic reasons for the further tightening.
In fact, the ECB has not changed its hawkish stance despite the latest inflation figures (at 2.4% in November in the Eurozone) prompting even the German hawk on the executive board, Isabel Schnabel, to admit she had misjudged prices. 'When the facts change, I change my mind,' Schnabel said. Monetary policy, however, has not yet changed. Many board members (especially those of Germany, Austria, the Netherlands, Belgium and the three Baltic countries) want to avoid the reputational fallout of underestimating inflation, regardless of the cost to the economy. Central bankers, however, should minimise the damage to growth, especially in the face of worrying signs for GDP and sharply declining risks on inflation.
The Fed's pivot
This is precisely why the Fed is moving 'cautiously' on rates, as Chairman Jerome Powell has been repeating for months. On 13 December there was the first pivot. The members of the US central bank indicated a median forecast of three cuts in 2024 (still less than the six expected by the market) and began discussing the timing of the reduction, despite the fact that the US GDP grew at an annualised rate of 5.2 per cent in the third quarter.
The Fed's pivot immediately put pressure on rates globally. Money markets indicate a 60% probability of an ECB cut as early as March. Overall, traders expect six cuts (for a total of 1.5%) in 2024 also in the Eurozone. Excessive euphoria in the markets could, however, complicate the ECB's work because the loosening of financial conditions can push up inflation. The drop in rates was evident on government bonds: the yield on the two-year Btp fell in two months from 4.1 to 3.1 per cent. Markets are discounting the forecast of a recession, not expected by the ECB. The economists of the major investment banks are more cautious and see the first cut in April or June.
For the ECB, the March projections will be decisive
Lagarde has invited to observe economic data, in particular labour market data, in the first half of the year. But the ECB could show a different orientation already in March if, as expected by economists, there will be a new downward revision of GDP and inflation estimates in the Eurozone in the macro projections.
