Inflation has been falling fast across the euro zone, with the headline rate now below the 2 per cent target set by the European Central Bank (ECB). While the underlying picture will still concern the ECB in some respects, there is a strong case for another reduction in interest rates when its governing council meets this week.
Monetary policy is always difficult to judge due to the long lags before it has its full impact. And so as inflation has started to fall from the peaks reached following the surge in energy prices, the ECB has had to judge the pacing of the initial interest rates cuts from their record highs. To date there have been two cautious quarter point reductions. A third now looks to be on the way this week.
The ECB has not always done a good job in communicating its position in recent months. Reflecting in part some internal tensions on its governing council, it has gone from saying it would not give an ongoing commentary on its policy options to doing just that. Or at least members of its governing council have done so.
In turn, this has given confusing and in some cases inaccurate signals to households, businesses and the markets. After the first interest rate cut in June, for example, some senior ECB figures indicated just one further reduction was likely this year. Now they look set to vote through a third reduction, with a fourth in prospect in December.
‘A rental is still your home’: How to decorate when renting without risking your deposit
Pat Leahy: Someone should take Simon Harris’s phone away before he bankrupts the country
Motivations of the Irish who served in the first World War were complicated
Mike Tyson couldn’t turn back time, but he knew that all along
This change of outlook relates to two things. One is a shift in the balance of risks facing the ECB. The growth outlook for the big euro zone economies has weakened significantly, reducing inflationary pressures. Germany looks set to record a shrinking economy for two years in a row.
Rather than a resurgence of inflation, a return to the sub-par growth and inflation of the pre-Covid period could now be seen as being the greater risk. On the flip side, there is still evidence of strong inflation in the services sector.
The second issue is that interest rates are already at relatively high levels. This means that they can still be cut a bit further without running significant risks of reigniting inflation.
The ECB also faces a key decision now on how it communicates its future intentions to the markets on Thursday. It has been saying that interest rates would be set on a meeting-to-meeting basis but needed to remain restrictive. This strategy is starting to look a little threadbare. Instead it may indicate that interest rates are now on a downward path towards more normal levels.
Borrowers here will welcome lower interest rates, though an Irish economy at full capacity does not need them. Nor does the Irish housing market, where figures this week are likely to indicate ongoing price pressures. All this puts the onus on the need for cautious domestic policy, a requirement not in evidence in the recent budget which will add to demand in the short term.