There’s been a pretty open debate among ECB (European Central Bank) members about whether to cut rates or pause at the upcoming meeting. The last major data point that could give a clearer indication on what to expect will be coming out just days before the June 5 rate decision. Part of the data has already been released, but the major figures are still waiting.
The issue that the ECB is facing now that it is ramping down its interest rate is the risk of an inflation undershoot undershoot. It takes months for the effects of monetary policy to filter through to the real economy. This is why a central bank will often start cutting rates before inflation has moved below target. With the EU economy facing stagnation this year, there is a risk that inflation will keep going down over the next couple of months and create another headache for the ECB.
Going Off the Rails
Inflation naturally occurs with economic activity. But the situation that the ECB (European Central Bank) has been dealing with hasn’t been entirely “natural”. Recent high inflation has come on the back of increased energy costs and a restructuring of the energy market in the wake of Russia’s invasion of Ukraine. Now, the trade war threatens to change consumer prices without a reference to economic activity – or borrowing from banks.
The central bank only controls how much it costs to borrow money, and through that has an influence on how much money is in circulation. But when governments intervene, then consumer behavior can get decoupled from the cost to borrow money. And that’s how inflation can get away from the central bank. The ECB is facing that very scenario at the moment.
Getting the Timing Right
The initial assessment of the trade war was that it would raise prices, including in Europe. That was based on the expectation that the EU would slap on retaliatory taxes. But the Trump Administration’s way of threatening tariffs and then pausing them has upended that assessment. The US has put on tariffs, but the EU has largely not raised import taxes (the small amount in retaliatory taxes over steel and aluminium is miniscule compared to the size of the EU economy).
As a result, the ECB (European Central Bank) is now facing the possibility that tariffs will lower inflation in the common market. Which means it could be behind the eightball, and inflation could fall faster than anticipated, necessitating even more cuts than the market is currently expecting.
What the Market is Looking For
We already got some signs of that on Tuesday when French harmonized CPI came in at -0.2% in the month of May, instead of the +0.2% expected. This dragged the annual inflation rate down to 0.7% from 0.8% prior, instead of rising to 1.0% that was expected. Germany will have its turn on Friday, when flash monthly May CPI is expected to stay flat, slower than the 0.4% reported a month earlier. This would bring the annual rate down to 2.0% from 2.1%.
The real test comes next Monday, when the Euro Area is expected to post an annual inflation rate of 2.1%, down from 2.2% prior. But lower than that could get the market to start pricing in a more aggressive rate cutting trajectory from the ECB.