The European Central Bank kept its interest rates unchanged on July 18th as expected as inflation stagnated above the bank’s 2% target. While inflation declined significantly during the second half of last year, it remains stubbornly above the 2.4% mark since November 2023. As a result, the ECB could remain cautious in its decisions in the coming months.

In this regard, the ECB stated that although inflation was in line with expectations, domestic price pressures were still high and inflation could remain above its 2% target well into next year. The bank and the market could thus continue to react to the upcoming economic data and the ECB could continue to make use of its monetary policy tools to enforce its 2% goal.

Shifting Direction

While the ECB aggressively tightened its monetary policy and kept its rates elevated for multiple months, its June meeting opened the way toward a different direction. In response to a slowdown in inflation, the European Central Bank decided to reduce its interest rate during its June meeting, marking a significant policy shift.

The ECB's decision came at a time when the Eurozone economy continues to see sluggish growth and remains vulnerable to global economic uncertainties. Factors such as fluctuating oil prices, trade tensions, and tariffs could further complicate the ECB’s plans. However, lower interest rates could reduce the burden of existing debt for governments and private entities, potentially spurring more economic growth.

What Comes Next?

While markets were expecting the ECB to cut rates two more times this year, sticky inflation could limit expectations for a third cut in December. Policymakers and markets could remain attentive to new data releases. In addition, the decision and approach of the ECB at its next meeting could influence expectations. However, another interest rate cut is still widely anticipated for the September meeting.

A softer inflation and weaker economic conditions could prompt the ECB to adopt a more dovish position on monetary policy. Such a direction could provide a cushion for the Eurozone economy against ongoing economic headwinds. However, lower interest rates could create risks of reigniting inflation at a time when strong wages and geopolitical constitute inflationary risks.

Sustaining the Eurozone Economy

Lower interest rates are expected to have several positive effects on the Eurozone economy. By reducing the cost of borrowing, the ECB could encourage higher levels of investment and consumption. This, in turn, could boost economic activity and help counteract the current economic weakness. Additionally, lower interest rates can ease the burden of existing debt, providing relief to both governments and private entities.

Global economic factors also play a crucial role in the Eurozone's economic performance. Fluctuations in oil prices, trade tensions, and other external factors can impact the region's economic stability.

Is The Fed Following The ECB’s Footsteps?

The ECB started cutting rates before the Federal Reserve and could continue to do so at a faster pace due to a weaker economy in the Euro area if inflation slows down. As a result, the ECB could have less room to leave rates elevated for long.

In contrast, healthier economic fundamentals and slightly higher inflation in the US could support high interest rates. However, due to its dual mandate, the Fed could remain attentive to the state of the job market. As a result, the Federal Reserve could move less aggressively than the ECB if the job market remains resilient and inflation stays elevated.

Interest Rate Cuts Weigh On The Euro

The ECB's interest rate cuts have significant implications for the euro. If the ECB reduces rates at a faster pace than other central banks, the euro could come under pressure. The currency could lose ground more rapidly against currencies with a stable monetary policy outlook or with potentially increasing rates like the Japanese yen.

However, a weaker euro might benefit Eurozone exports by making them cheaper on the global market, thus boosting the region's economy. However, this could also lead to higher import costs and potential capital outflows as investors seek higher returns elsewhere.

Source: London Loves Business