ECB Expresses Concerns Over Market Expectations on Rate Cuts Impacting Disinflation

The European Central Bank (ECB) has voiced apprehensions that investor expectations for rate cuts as early as March may have loosened financial conditions to a degree that could disrupt the disinflationary process, according to minutes from the ECB’s recent meeting.

During the December 15 meeting, members of the ECB’s governing council expressed the need to counter market expectations of imminent interest rate cuts. The minutes revealed a consensus that June would likely be the earliest juncture at which policymakers could assess if inflation had been effectively subdued.

The ECB emphasized the importance of not aligning post-meeting communications with market expectations, underscoring the need to avoid complacency. Recent comments by ECB President Christine Lagarde, indicating that borrowing costs would not decrease until summer, led to a global sell-off in bond and equity markets.

The tension between the ECB and the markets highlights a disparity in expectations, where investors anticipate a more rapid decline in inflation than the central bank is forecasting. This expectation could potentially pave the way for policymakers to initiate reductions in the benchmark deposit rate, currently at a record-high level of 4%.

The ECB minutes reveal that policymakers in the eurozone were already concerned about the potential impact of market expectations on derailing disinflation. This concern was reiterated by Gita Gopinath, the first deputy managing director of the IMF, who cautioned central banks against hastily cutting rates.

In terms of economic indicators, the eurozone witnessed a slowdown in annual price growth from a peak of 10.6% in October 2022 to a two-year low of 2.4% in November. It rebounded to 2.9% last month after the phasing out of government energy subsidies.

Policymakers deliberated on the stickiness of inflation during its decline to the 2% target, with a focus on wage growth as a crucial factor. While most anticipated a slowdown in wage growth in response to falling inflation, they also acknowledged several upside risks to inflation, including geopolitical tensions impacting energy prices and extreme weather events affecting food costs.

The ECB maintained a cautious stance, emphasizing the need to remain sufficiently restrictive in light of the remaining distance of inflation from the 2% target. Analysts, such as Carsten Brzeski of Dutch bank ING, interpret the minutes as indicating that the ECB is still distant from discussing rate cuts, with this stance unlikely to change in the upcoming meeting next week.

The recent increase in borrowing costs since mid-2022 has had a notable impact on Europe’s construction sector. EU construction production was down 2% in November from a year earlier, with Germany, France, the Netherlands, Hungary, Poland, Austria, and the Nordic region experiencing a decline.

Separate data from Germany’s federal statistical office revealed a continued decline in building permits for apartments, falling 16.9% from a year earlier in November. This decline may result in a shortfall in meeting the German government’s target of 400,000 new housing units.

German house prices have already fallen 10% from their peak in 2022, but some analysts, like Jochen Möbert of Deutsche Bank, anticipate a recovery in the housing market in the coming year due to housing shortages, relatively high wage growth, and low long-term Bund yields.

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