The ECB has no room to cut rates

The writer is a former supervisory board member of the European Central bank and a senior fellow at Bocconi University and the Leibniz Institute for Financial Research SAFE

It was a hot summer in Europe, not only for tourists. Central bankers on both shores of the Atlantic are under pressure from many sides — political circles, financial markets, public opinion — to cut interest rates.

All central banks are facing this equally, regardless of economic conditions or where their policy rates happen to be at the moment.

Multiple arguments are being cited. Inflation has been declining steadily towards the 2 per cent target — though progress is called into question by the fact that core measures lag behind. Recession fears linger — in spite of the fact that incoming data is not flagging red; the US economy continues to create a sizeable (though declining) number of jobs every month, and in the euro area economic expectations are not far from their long-run average, according to a European Commission survey.

A sudden stock market crash in the first week of August spooked observers — even though in the end it proved to be a fluke: the US stock market index S&P 500 subsequently rallied in the month afterwards. What better reasons, many think in spite of the counterarguments, to slash interest rates?

Now, as the September policy meetings approach, central banks would be well advised to think twice and redo their calculations. The key point to be realised is that they are not all in the same spot. For the US Federal Reserve, the case for a cut is persuasive. At a 23-year high of 5.25 per cent to 5.5 per cent, the benchmark federal funds rate is some 3 per cent above current readings of its preferred inflation gauge.

With inflation on a gentle downward path and labour markets apparently landing softly, a 0.25 percentage point cut would send an encouraging signal while maintaining the restrictive stance needed to complete the disinflation process. A 0.50 percentage point cut would be a stretch, but still fulfil the criterion. Chair Jay Powell indicated in his August Jackson Hole speech that the time to cut rates had come, saying “the direction of travel is clear”. That view continues to be justified as the US summer draws to an end.

The Bank of England’s guideposts are close to the Fed’s, with consumer inflation a tad nearer to the 2 per cent target but expected to rebound. The difference here is that the central bank already cut its rate before the summer break — a controversial decision adopted against the vote of its chief economist Huw Pill. The case for cutting again is less strong than it was in July, and less strong than it is for the Fed now.

The European Central Bank is in a completely different situation. Not only did it already cut rates before leaving on holiday but what matters more is that, at 3.75 per cent, its rate is already a solid 1.5 percentage points below that of its peer across the ocean. This is an inheritance of the 2014-2019 period, when the central bank experimented with negative rates and kept them there for about a year after inflation had started rising.

That course of action means that today the ECB has less room than other central banks to loosen its policy. Never forget: the monetary stance depends on interest rate levels, not changes. The latter are at most indications of possible future levels.

The last reading of headline inflation in the Eurozone, at 2.2 per cent in August, 0.4 percentage points below the July level, provides less comfort than it seems. Core inflation, at 2.8 per cent, did not change. Services inflation, a sticky component representing nearly half of the index, moved up from 4 per cent to 4.2 per cent. The August drop of headline inflation depended fully on a major, but possibly erratic, fall of energy prices. This is an encouraging signal for the future, not a conclusive prompt to act now.

The ECB needs to maintain a moderately restrictive stance to make further disinflationary progress. As its chief economist, Philip Lane, said at Jackson Hole, “the return to target is not yet secure”. The current level of real short-term rates, at some 1.5 per cent or actually lower if one uses core inflation to deflate the nominal rate, is needed for that purpose. The ECB should maintain that level in September.

Christine Lagarde has often stated that the central bank she leads does not follow the Fed but charts its own course, because the two economies are different. The ECB president is right. This September meeting is the occasion to put that statement into practice.