ECB set to cut interest rates again as inflation takes a back seat to Trump

The European Central Bank is set to cut interest rates again next week, determined to do its bit to support an economy beset by a host of problems largely outside its control.

For four years, the ECB has been trying to slow the economy down, raising its key deposit rate to a record 4 percent to choke off inflation, before gradually lifting its foot off the brake since June. Next week’s expected rate cut will be the sixth in the current sequence, and will bring the deposit rate down to 2.5 percent.

But it’s what comes after the Governing Council’s decision on Thursday that is the interesting bit. ECB President Christine Lagarde will be under pressure to communicate clearly where rates will go for the rest of the year, at a time when the changeable rhetoric and actions of U.S. President Donald Trump make clarity effectively impossible.

Were it not for Trump, Lagarde’s task might be relatively straightforward. Growth is still weak, inflation still appears to be falling back toward 2 percent, and there is little in any of the data that the ECB attaches importance to, such as wage and credit growth, to stop it easing policy further.

Against such a backdrop, senior members of the Governing Council such as Bank of France Governor François Villeroy de Galhau and his Greek colleague Yannis Stournaras have confidently predicted further cuts over the rest of the year, endorsing market forecasts that see the deposit rate at 2 percent.

Analysts at Barclays said in a note to clients this week that the ECB may be forced to go even lower, if Trump proceeds with his various threats.

“Further trade-war escalation between the U.S. and the [eurozone] is likely to have notable consequences on economic activity in the euro area,” Mariano Cena and Saadalla Nadri-Yazji argued, by breaking supply chains, creating production bottlenecks, and, “most importantly, generating uncertainty, hence delaying investment and consumption decisions.”

In purely domestic terms, the picture has become slightly clearer for the ECB since its last meeting: elections in Germany have produced a clear path to a new and likely business-friendly government, while in France, Prime Minister François Bayrou has squeezed a budget through parliament without triggering fresh political instability.

Guessing game

But the best that can be said for the economy is that it has stopped getting worse in recent weeks. The latest round of real-time business surveys point to a modest improvement in the fortunes of the beleaguered manufacturing sector, while those sectors that respond most to interest rates, such as construction, are picking up slowly. However, rising unemployment is undermining consumer confidence, frustrating the ECB’s efforts to get people spending again.

That explains why some on the Governing Council are keen to remove any “restrictiveness” from the ECB’s stance as soon as possible. The level of 2 percent is bang in the middle of a range that is the ECB’s best guess of what constitutes a “neutral” interest rate: that is, one that is no longer “restrictive” but is not yet “stimulative.”

But while the ECB is unanimous in thinking that policy should not hold the economy back any longer, some are starting to doubt that it is still doing so anyway. Head of markets Isabel Schnabel argued this week that “we can no longer say with confidence that our policy is restrictive,” pointing to upheavals in the global economy over recent years that have on balance probably raised the natural rate of interest.

For this reason, she said, the ECB should be careful about cutting rates any further. Over the last week, fellow ‘hawks’ Joachim Nagel and Pierre Wunsch have also signaled unease about telegraphing further easing.

Head of markets Isabel Schnabel argued that the ECB “can no longer say with confidence that our policy is restrictive.” | Andrew Caballero-Reynolds/AFP via Getty Images

It makes a fine talking point for bean-counters. But with so many more easily identifiable risks out there, many analysts fear the argument over “neutral” policy will soon be followed by one over how much stimulus is needed.

“Eventually,” said Carsten Brzeski, global head of macro at ING, “the structural weakness of the eurozone economy as well as looming tariffs and lower inflationary pressure on the back of a turning labor market will force the ECB to bring rates down to at least 2 percent, even if not all ECB members might like it.”