Interest rates likely to drop in Europe

The European Central Bank (ECB) is expected to lead the way in reducing interest rates ahead of the U.S. Federal Reserve, marking the eurozone as the first major developed economy to ease borrowing costs for businesses and consumers as inflation from the Ukraine conflict begins to wane.

ECB President Christine Lagarde, along with other officials, has indicated that a quarter-point reduction from the current record high of 4% is likely when the ECB’s 26-member governing council meets in Frankfurt, Germany.

Lagarde expressed confidence late last month that inflation in the eurozone, which comprises 20 EU countries using the euro, is under control. Analysts now widely expect a rate cut to be announced on Thursday.

This anticipated move contrasts with the early days of the inflation surge when the Fed was quicker to tighten credit by raising rates starting in March 2022. This approach increased mortgage costs but also boosted returns for savers. The ECB began raising rates about four months later.

Globally, major central banks are leaning towards lowering interest rates. Smaller economies like Sweden, Switzerland, Hungary, and the Czech Republic have already cut rates. The Bank of England will meet on June 20 to discuss a possible rate cut from 5.25%, while Japan, which has had below-zero rates and low inflation for years, has just begun raising rates.

Europe’s inflation spike was initially driven by Russia cutting off natural gas supplies and supply chain disruptions following the COVID-19 pandemic. Although Europe was heavily impacted initially, the energy price surge has subsided, and inflation dropped to 2.6% in May, down from a peak of 10.6% in October 2022, nearing the ECB’s target of 2%.

In contrast, the U.S. faces different inflation drivers such as government stimulus, pandemic recovery spending, and robust economic growth. The U.S. consumer price index currently stands at 3.4%, higher than the Fed’s 2% target. Fed Chair Jerome Powell has indicated that the Fed expects to cut rates this year, though no changes are anticipated at the upcoming June 11-12 policy meeting.

The divergence in rate policies between the ECB and the Fed could theoretically weaken the euro against the dollar by attracting more investment into dollar-denominated assets. However, the euro has recently strengthened from $1.06 in mid-April to around $1.09, despite the anticipated ECB rate cut.

Higher interest rates combat inflation by making borrowing more expensive, thus lowering demand and easing price pressures. However, they also slow down economic growth, which has been weak in the eurozone. The eurozone’s economic output has hovered around zero growth for over a year, though there was a slight uptick in the first quarter of this year with a 0.3% GDP increase.

Holger Schmieding, chief economist at Berenberg Bank, noted that the ECB’s actions are justified by the differing inflation and growth dynamics between the eurozone and the U.S. He suggested that the eurozone’s recent stagnation indicates the ECB may have overreacted with rate hikes, making a rate cut sensible.

Analysts believe that while a quarter-point cut is expected on Thursday, it likely won’t lead to a rapid series of additional cuts as the ECB monitors inflation and credit conditions. Inflation in the services sector, a broad category including healthcare, hospitality, and entertainment, remains high at 4.1%.

Interest rates set by central banks are crucial for both markets and consumers, influencing borrowing costs for mortgages, credit cards, and more. Lower rates can lead to higher stock prices and increased value in retirement accounts as investors seek higher returns in riskier assets.

In Germany, higher ECB rates ended a nine-year housing price rally and slowed construction activities sensitive to borrowing costs. They also increased upfront costs for renewable energy projects vital for Europe’s climate goals under the 2015 Paris Agreement.