The European Central Bank (ECB) reduced interest rates by 25 basis points to 3.25%, reflecting confidence in the Eurozone’s disinflationary trend in October 2024. This marked the third consecutive rate cut as inflation cooled, with consumer prices rising 1.7% year-on-year.
Starting December 18, 2024, there has been another rate cut with the deposit facility rate being 3.00%, the main refinancing rate being 3.15%, and the marginal lending rate being 3.40%.
The ECB aims to support economic stability amid sluggish growth and easing inflation pressures in the coming year.
Let’s understand why the ECB has been cutting interest rates time and again.
What does the recent ECB rate cut suggest?
The recent discussions within the European Central Bank suggest a potential shift toward more aggressive monetary easing, signaling a change in its policy direction. Policymakers are now debating whether interest rates should be cut further to stimulate the Eurozone’s sluggish economy, a departure from the neutral stance of balancing inflation without stimulating or restricting growth.
While the ECB has been cutting rates this year, the focus has been on maintaining stability. However, sources indicate that growing economic challenges, including falling inflation rates and weaker-than-expected growth, may require deeper rate cuts than initially planned. Inflation is now running well below earlier projections, raising fears of prolonged disinflation, similar to the post-2008 period, when inflation persistently undershot targets.
Some policymakers believe the ECB risks falling behind the curve, advocating for a more proactive approach to prevent further economic downturns. They suggest reconsidering the current ‘meeting-by-meeting’ decision-making process and dropping references to maintaining restrictive rates. This would signal a serious focus on downside risks and a willingness to take decisive action if needed.
Reasons behind the ECB rate cut
The European Central Bank (ECB) recently cut interest rates in response to the rapid cooling of inflation across the Eurozone. This sharp slowdown in price growth marks a shift from the high inflation levels caused by the pandemic and geopolitical tensions in recent years.
The ECB has been closely monitoring inflation trends, and the swift reduction in inflation has prompted policymakers to ease monetary policy to ensure inflation returns to its 2% target without falling too low. The three main reasons behind the ECB rate cuts are –
Rapid cooling of eurozone inflation
The ECB’s latest interest rate cut was driven by the rapid decline in inflation across the Eurozone. After experiencing significant inflationary pressures due to the pandemic and geopolitical disruptions, inflation has cooled more quickly than expected.
September’s data showed that consumer prices rose by 1.7% annually, a decrease from the previously reported 1.8%. This deceleration has provided the ECB with confidence that inflation is stabilizing, reducing the need for tighter monetary policy. Policymakers have now shifted their focus from combating high inflation to ensuring inflation does not drop too far below the 2% target, which could trigger deflationary risks and harm economic growth.
Recent downward revision of inflation data
In addition to cooling inflation, a downward revision of previous inflation data motivated the ECB to cut rates. The revised September inflation figures, which were adjusted down from 1.8% to 1.7%, indicated weaker-than-expected price growth.
This revision confirmed that inflationary pressures are easing faster than anticipated, raising the risk of inflation undershooting the central bank's target. Policymakers at the ECB are concerned that if inflation falls too low, it could further weaken the economy and hinder recovery efforts, so they decided to act decisively by lowering rates. The revision further cemented the ECB’s stance that proactive measures are necessary to avoid deflationary risks.
Signs of economic weakness prompting the ECB's decision
Signs of broader economic weakness in the Eurozone have played a crucial role in the ECB’s decision to cut interest rates. Economic indicators, such as Purchasing Managers’ Index (PMI) data, have revealed stagnation or contraction in several sectors, pointing to a sluggish growth outlook.
In addition, Germany, the Eurozone’s largest economy, is teetering on the brink of recession, with its GDP contracting by 0.1% in the second quarter of 2024. These signs of weakening economic activity have increased the urgency for the ECB to ease borrowing costs to stimulate growth and support investment. By lowering rates, the ECB aims to provide relief to businesses and households while creating a more favorable environment for economic recovery.
Impact of the interest rate cut on the Eurozone economy
The European Central Bank’s (ECB) recent 25 basis point interest rate cut aims to stimulate economic growth across the Eurozone amidst easing inflation and stagnant growth. Lower interest rates can positively impact the economy by making borrowing cheaper for households and businesses and encouraging spending and investment.
For businesses, the reduced cost of borrowing can encourage investment in capital, innovation, and expansion projects that may have been postponed due to higher financing costs.
Companies may also use this opportunity to refinance existing debt at lower rates, improving their financial stability and freeing up capital for other purposes, such as hiring or research and development. This increased business activity can contribute to overall economic growth, especially in sectors like manufacturing, technology, and services, which may benefit from improved access to capital.
Moreover, the rate cut can positively affect exports by weakening the Euro, making goods and services from the Eurozone more competitive in global markets. A weaker Euro can boost export-oriented industries, supporting economies like Germany's that heavily rely on international trade. At the same time, increased consumer confidence due to lower rates could help offset some weaknesses in private consumption and investment that have weighed on eurozone growth in recent quarters.
For households, reduced borrowing costs make loans and mortgages more affordable, potentially increasing consumer spending on goods and services. Similarly, businesses benefit from lower financing costs, making investing in expansion, innovation, and hiring easier. This, in turn, can boost economic activity and create jobs, fostering overall economic growth. The decision comes as inflation has settled to a lower band in September, below the ECB’s target for the first time in three years.
By reducing borrowing costs, the ECB hopes to counter tepid growth, which stood at just 0.2% in the second quarter of 2024, and stimulate greater economic activity in the months ahead.
Concluding the future implications of the ECB rate cuts
Analysts predict that further rate cuts may be possible as the ECB monitors economic conditions. The central bank’s cautious ‘data-dependent’ approach means decisions will be based on inflation and growth indicators. Economists suggest that interest rates could settle at a neutral level between 2% and 2.5% by mid-2025, balancing growth without fuelling inflation.
