Why the ECB will remain cautious after the first rate cut

Announced in many ways, the June cut took place. The deposit rate was lowered from 4% to 3.75% and the reference rate from 4.50% to 4.25%. Assuming a real equilibrium rate around 0.5% - as suggested by research and extrapolations from market research summarised by Isabel Schnabel, a member of the board, in March - and long-term inflation at 2%, the policy rate will thus remain significantly higher than the nominal 2.5% that is the neutral level (not far from the US level, by the way). The latest, rather disappointing data, however, suggest that what will happen from July onwards is still very uncertain. Analysts and investors who were aiming for a cut every meeting - with the second reduction perhaps from September to assess the effects of the first step - are now being asked to revise their forecasts.

The reason is simple. Inflation, and inflation pressures, have - surprisingly - increased. The May figure showed prices rising at an annual rate of 2.6 per cent, after 2.4 per cent in April and March, and a core index rising to 2.9 per cent, from 2.8 per cent in April and 3.1 per cent in March. The downward trend has at least eased, and while a less trivial simulation of the historical series is compatible with a temporary recovery, it is clear that prices will now have to be monitored very closely.

The risk for the ECB at the moment is that inflation will stabilise at a level above the 2% target, which in the long run could affect the credibility of the monetary authority. Long-term market expectations - as measured by the inflation swap 5y5y - have long since left the target and stood at 2.24%-2.35%. Having adopted a point target, the ECB cannot necessarily be satisfied with inflation remaining at these levels.

The only element that could reassure the central bankers is the fact that the price trend of services - also accelerating to 4.1 per cent - and that of industrial goods, declining to 0.8 per cent, has never been so far apart. There are two possibilities: service prices, which are more rigid, register inflation expectations better and must be considered more important - this is the ECB's approach so far - or Euroland is also affected by a change in relative prices, which monetary policy must not touch.

It is also true, however, that inflation pressures from wages have increased. Negotiated wages accelerated again and in the first quarter of 2024 increased by 4.7%, the fastest rate since 1992. The labour cost per hour worked for the same period has not yet been calculated by Eurostat, but in the last quarter of the year it was still moving at an annual rate of 5.8%. The ECB has never regarded these trends as negative per se: it is healthy for consumers to regain at least some of the purchasing power lost through high inflation. Provided, however, that this boost is absorbed by profit margins, which increased greatly in the first phase of inflation.