Europe Central Bank jumps ahead of the Fed in lowering rates

The European Central Bank cut its key interest rate Thursday by a quarter-point, moving ahead of the US Federal Reserve as central banks around the world lean toward lowering borrowing costs — a shift with far-reaching consequences for home buyers, savers and investors.

The ECB cut its benchmark rate to 3.75 per cent from a record high of four per cent at a meeting of the bank’s 26-member rate-setting council in Frankfurt.

Speaking afterward at a news conference, ECB President Christine Lagarde said inflation had eased enough for the central bank to start lowering rates. But with inflation in the eurozone expected to remain above the ECB’s two per cent target into next year, Lagarde declined to say how fast or how deep any future rate cuts might be.

“Price pressures have weakened, and inflation expectations have declined at all horizons,” she said. “We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim… We are not committing to a particular rate path.”

Analysts say Thursday’s quarter-point rate cut will likely not usher in a swift series of further cuts as the ECB waits to make sure inflation has been brought under control. Though the annual inflation rate for May — 2.6 per cent — is well below a peak of 10.6 per cent in October 2022, the decline has slowed in recent months. Inflation even ticked up slightly from 2.4 per cent in April.

Inflation in the services sectors, a broad category that includes everything from medical care and haircuts to hotels, restaurants and concert tickets, remains particularly elevated at 4.1 per cent.

The ECB’s move represents a switch from the onset of the inflation surge, when the Fed took the lead in tightening credit by raising rates starting in March 2022, sending mortgage costs higher but also boosting returns for savers with money in certificates of deposit or money market funds. The ECB started four months later.

Major central banks around the world now are leaning toward lowering interest rates. Central banks in smaller economies have already cut rates, including in Sweden, Switzerland, Hungary and the Czech Republic. The Bank of England’s policymakers are scheduled to meet on June 20, but it’s not clear whether the governing board will cut the rate from 5.25 per cent. Japan, an economic outlier among the world big economies, has started raising rates after years of below-zero rates and low inflation.

Central bank benchmarks are a big deal for governments, companies, home buyers, investors and and savers. The benchmarks influence borrowing costs across the economy, so lower rates can mean lower mortgage costs and credit card charges for consumers. Lower rates also can boost stock prices and the value of retirement accounts since they lower returns on conservative holdings like bank accounts or certificates of deposit relative to stocks, and can mean stronger economic growth that will boost corporate earnings.

Rate increases combat inflation by making it more expensive to borrow in order to buy goods, lowering demand and taking the pressure off prices.

But high rates also hold back growth, and that has been in short supply in the eurozone, where the economy has shown very little growth recently.

The ECB’s higher rates quashed a nine-year-long rally in eurozone home prices and slammed construction activity, which is highly sensitive to borrowing costs. Higher rates have also raised the up-front costs for building new renewable energy production, raising fears that high rates could slow Europe’s transition away from fossil fuels under the 2015 Paris climate accords.

The inflation surge in Europe was unleashed first and foremost by Russia cutting off most natural gas supplies to the continent, and by logjams in supplies of raw materials and parts as the global economy rebounded from the COVID-19 pandemic.

Although the eurozone was hit first and hardest by the Russian cutoff, the resulting energy price spike has now largely subsidised and inflation fell to 2.6 per cent in May, down from a peak of 10.6 per cent in October 2022 and within range of the ECB’s goal of two per cent.

As the central bank with the world’s dominant currency, what the Fed does spreads ripples far and wide. Widening the rate gap between Europe and the US could in theory weaken the euro against the dollar by pulling more investment money out of the eurozone and into dollar holdings in search of higher returns.

That would hurt the ECB’s inflation battle by making imports more expensive. But in practice the euro has actually strengthened recently — from $1.06 in mid-April to its current level around $1.09 — even though the ECB has telegraphed a rate shift for weeks.

The Federal Reserve faces a very different economy, one in which inflation was fueled less by the Russian energy shock than by government pandemic recovery spending, and more robust growth fueled inflation. The US consumer price index is at an annual 3.4 per cent, some way from the Fed’s goal, also two per cent.

Fed Chair Jerome Powell has said the bank expects to cut rates this year from the current benchmark level of 5.25 per cent-5.5 per cent, but no change is expected at the Fed’s next policy meeting on June 11-12. With inflation cooling slowely in the US, economists and investors now increasingly expect only one or two cuts this year.

Growth in economic output has hovered just above and below zero for more than a year before a modest upbeat surprise in the first three months of the year, when gross domestic product rose 0.3 per cent from the quarter before.

“While it is noteworthy that the ECB is forging well ahead of the US Fed, the transatlantic difference in inflation and growth more than justifies this, in our view,” said Holger Schmieding, chief economist at Berenberg bank.

“If anything, the five quarters of stagnation in the eurozone economy from autumn 2022.

By David McHugh

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