The ECB in 2024: rate cuts, balance sheet reduction and a new operational framework. Here’s what to expect

The year 2024 will mark the ECB's change of course on interest rates, while from mid-year the reduction of the balance sheet will accelerate and in spring the central bank's new operating framework will be launched. In 2023 the strongest monetary tightening in the history of the euro, which will be 25 years old in January, will be completed. Between July 2022 and September 2023, the ECB raised deposit rates from -0.50% to 4%. Moreover, the balance sheet has already shrunk by almost 2 trillion (from 8.830 billion at the peak in June 2022 to 6.9 trillion).

All this was done with the aim of avoiding an inflationary spiral triggered first by the pandemic and then by the rise in energy prices due to the war in Ukraine. 2023 was also the year of the sharp drop in Eurozone inflation, which fell to 2.4% in November from its peak of 10.6% in October 2022. But the fall was a consequence of the drop in gas and oil.

Monetary policy, which reaches the economy about a year and a half late, has only just begun to make itself felt. The maximum effect will come in the coming months, when inflation will be back close to the 2% target. In December there will be an increase (to 2.9-3.1%) due to the comparison with extraordinary factors from the year before. The data from the beginning of 2024 and the new ECB projections in March will be decisive. Then much will be understood about rates. Soon it will have to be decided when to lower them and by how much. In this respect, the ECB and the markets currently have different ideas.

Economic outlook divides ECB and markets

ECB President Christine Lagarde showed even after the last Governing Council on 14 December more attention to price increases than to growth. Lagarde fears wages and 'domestic' inflation in particular, although the position has not convinced economists (see Milano Finanza of 23 December). Other board members imagine a possible recovery in consumption. The hawks of the Governing Council, led by Isabel Schnabel, have long held the line of a difficult 'last mile' of disinflation. This line has been contradicted by the latest data: even Schnabel has admitted that she was wrong in her assessment of prices. But despite this the ECB has so far not changed monetary policy. On the contrary, it has accelerated the reduction of the balance sheet through less reinvestment of securities from the Pepp pandemic plan from mid-2024.

It will be seen whether there really will be a last mile of disinflation or rather a 'last metre' or a 'hundred metre race', as Citi and Bnp Paribas have speculated. The hawks want to postpone the rate cut until the second half of the year. The latest ECB projections from December, which show inflation at 2.7% in 2024 and 2.1% in 2025, also point in this direction. The inflation rate would return to 2% from mid-2025.

However, according to economists and market analysts, the ECB could face a faster decline in inflation. The central bank has already underestimated the 2023 decline. At the same time, economic growth could suffer from the monetary tightening more than expected by the ECB (which sees a GDP increase of 0.8 % in 2024). This scenario would lead to a stronger decline in rates.

Expectations on rates

Most economists expect the first cut in April. Money markets see a 70% probability of the first cut in March, followed by six more cuts in 2024. This view clearly clashes with the position of the ECB, which, unlike the Fed, has not even begun to discuss a cut despite a much weaker economy.

The ECB may thus have reacted to the inflationary shock with an excessive restriction. The trend of inflation shows that the decrease (between October 2022 and November 2023) occurred at the same speed as the increase (between October 2021 and October 2022). This movement seems to indicate that inflation experienced an energy-related supply shock, which lasted longer than expected due to the double crisis (pandemic and war). Instead, the ECB reacted to 'dampen demand', as has been indicated for months.

Excessive tightening by the ECB would produce unnecessary damage to the economy. This has been pointed out repeatedly by Bank of Italy Governor Fabio Panetta. In early 2024, the ECB could find itself in a difficult position. GDP data will be published in the fourth quarter of 2023: the Pmi indices signalled the beginning of recession in the Eurozone. Credit, due to the full transmission of monetary policy, could fall even more than it is doing, especially towards businesses: in the coming months a significant amount of fixed-rate debt will mature and have to be renewed at higher costs.

Government policies will be more restrictive after years of spending to cope with pandemic and energy crises, when the Stability Pact was frozen. Germany in particular could be the area's drag, due to the necessary restructuring of the economy and the self-imposed budget tightening by the 'debt brake', especially after the recent German Constitutional Court ruling. It is no coincidence that even German central bankers have been more cautious in recent statements. Moreover, the ECB risks having to adjust to a more dovish Fed: in recent days the euro has strengthened against the dollar to its highest level in five months.

For the Eurozone there is not only the risk of growth: inflation could also end up below the 2% target (it will be 1.7% in 2025 for Citi and 1.8% for Unicredit) and this would be just as much of a problem as an over-target figure. In that case the ECB will have to cut rates, if not seven times as the markets indicate, certainly more quickly than the recent statements by Lagarde and the hawks suggest. The December ECB projections were considered hawkish by many economists. The Eurozone figure was affected by the Bundesbank's forecast for Germany, the only one among the big countries not to reach 2% inflation in 2025, despite the difficulties of the German economy.

Balance sheet reduction and revision of the operational framework

The Pepp revision will increase the balance sheet reduction (Quantitative Tightening or Qt) from mid-2024. The central banks in Northern Europe want to decrease the banks' excess liquidity as much as possible and also increase reserve requirements in order to record fewer losses. The revision of the operating framework will be completed in spring.

Schnabel pushes for a 'demand-driven' system, based on refinancing requested by banks (with market rates, thus different from LTROs), and opposes chief economist Philip Lane's idea of a structural portfolio of securities, a more credit-friendly option. Lane echoed the indications of some of the ECB's top economists (the director of monetary policy Massimo Rostagno, Carlo Altavilla and Julian Schumacher) who pointed out in a paper: 'A neutral QT should run at the expected pace until mid-2026. Then, the balance sheet should start growing again to finance the secular growth in the demand for central bank liabilities'. This matter could also become a topic of discussion at the ECB board in 2024.