Will the European Central Bank have a larger rate cut? Policymakers express caution, traders remain fixated
European Central Bank officials tend to favor a gradual interest rate cut (25 basis points), but traders believe there may be a future rate cut increased to 50 basis points. The market is focused on eurozone inflation expectations falling below 2% and economic activity shrinking. Policymakers such as Francois Villeroy de Galhau support retaining the option to cut rates and expect to discuss the possibility of a 50 basis point cut at the December meeting. Despite the inflation target being 2%, high wages and low unemployment rates still impact market sentiment
According to Zhitong Finance APP, investors and economists cannot completely shake off the idea that the European Central Bank (ECB) will implement larger rate cuts in the coming months. Although most ECB officials prefer a "gradual" (i.e., 25 basis points) rate cut, traders do not rule out the possibility that the ECB may double the rate cut to 50 basis points at one of its next three meetings.
Traders are currently focused on a key indicator measuring inflation expectations in the Eurozone falling below 2%, as well as some surveys indicating that economic activity in the Eurozone is contracting. Meanwhile, influential policymakers, including ECB Governing Council member and Governor of the Bank of France Francois Villeroy de Galhau, have also fueled market bets that the ECB will increase the magnitude of rate cuts—Francois Villeroy de Galhau urged his colleagues to retain full flexibility regarding the scale of rate cuts.
The ECB seems likely to discuss the issue of a 50 basis point rate cut at its policy meeting on December 11-12. ECB Governing Council member Martins Kazaks warned last week that uncertainty "remains very high," and officials "will certainly discuss this issue."
The market's bet on the ECB potentially making larger rate cuts is primarily due to the difficulties facing the European economy. The Eurozone's November PMI data indicates a bleak outlook for economic recovery, while political turmoil in the Eurozone's two largest economies—Germany and France—is affecting market sentiment.
However, the market has reasons to remain cautious about inflation. Although ECB policymakers believe that inflation will continue to meet the 2% target next year, wage growth remains high, the unemployment rate is at historical lows, and service prices continue to rise significantly.
Christian Keller, head of economic research at Barclays, stated, "I would almost rule out the possibility of a 50 basis point rate cut by the ECB in December, even though the market still believes there is such a possibility." "This possibility may increase in the first quarter of next year, but currently, most signals indicate that the ECB will continue to cut rates gradually."
Jordan Rochester, head of macro strategy at Mizuho, also noted that economic conditions may require a 50 basis point cut, but the ECB's response mechanism is closely related to past inflation, which remains the reason it may ultimately only cut rates by 25 basis points.
Most analysts agree with this view. Only JP Morgan has brought forward its expectation of a 50 basis point rate cut by the ECB from January next year to this month, citing the fragility of the Eurozone economy, slowing service sector inflation, and trade uncertainties.
Economists surveyed expect that by June next year, the European Central Bank will cut interest rates by 25 basis points at each policy meeting until the deposit facility rate falls to 2% (currently at 3.4%). Earlier, economists had anticipated that the eurozone deposit facility rate would not reach the 2% level until the end of next year.
The European Central Bank will also release its latest forecasts this week—especially economic forecasts—that may clarify the situation somewhat. The ECB will project the economy through 2027 and attempt to explain an increasingly lengthy list of risks, including fiscal concerns, trade tariffs, geopolitical conflicts, and more.
Given these highly unpredictable risks, ECB policymakers generally prefer to take gradual actions rather than bind themselves to a firm easing path. ECB President Christine Lagarde stated last week, "Although we are on a path of declining inflation, and we know that the direction of interest rates is downward, the speed of that decline is not predetermined." "I certainly will not commit to any specific numbers."
Other reasons hindering the ECB from making larger rate cuts include the euro. Since Trump won the U.S. presidential election, the euro has fallen by about 3%. Although ECB officials have not set specific exchange rate targets, this decline could trigger new inflation concerns. Additionally, more aggressive rate cuts could signal to investors that the eurozone economy is in trouble, potentially leading to a 50 basis point cut.
Economists at Nordea, including Tuuli Koivu, believe that a 50 basis point cut in December would put the ECB on a path to lowering rates below the neutral rate, possibly below 1.5%.
All of this may explain why even the most dovish ECB policymakers have not indicated support for larger rate cuts. However, this has not stopped traders from preparing for such a potential scenario. SEB Research Chief Strategist Jussi Hiljanen stated, "By March next year, the anti-inflation process should have progressed far enough to make the ECB Governing Council more forward-looking, facilitating larger rate cuts."