“Lowering rates doesn’t seem compatible with the current state of the economy”

Monetary policy continues to be the main driver of the markets, which kept a very close eye last week on the March meeting of the European Central Bank (ECB). The ECB decided to keep the three official interest rates unchanged for the fourth consecutive time, leaving the lending rate at 4.75%, the main financing rate at 4.50% and the deposit facility rate at 4.00%.

On the balance sheet side, it maintained the roadmap through which it aims to reduce its size at a measured and predictable pace, as well as continuing with the planned change to the Pandemic Emergency Purchase Program (PEPP), which will give way to an interruption of reinvestments at the end of 2024 as well as a reduction process (in the second half of 2024) worth 7.5 billion euros per month on average.

The organization also presented new forecasts, revising both inflation and economic activity in the Eurozone downwards, the latter to a lesser extent. Despite offering few changes compared to December, this outlook lays the foundations for a more balanced vision in terms of both growth, which could well speed up in the second half of 2024, and price stability, with a predicted return to the central bank’s target within the forecast horizon for 2025.

With this in mind, MAPFRE Economics, MAPFRE's research arm, explains how, at this most recent meeting, the ECB reinforced the message that the debate on lowering rates remains premature. However, some hints were given by pointing to the months of April and June as being pivotal in terms of incoming data, allowing for a decision that distinguishes "signals from noise".

"The key points of the meeting can be summarized as an ECB that remains reflective while waiting for conclusive signs of change. Therefore, applying interest rate cuts would not appear to be a rational decision nor compatible with the current state of the economy,” explains MAPFRE Economics in a recent report.

This condition, combined with the influence of a geopolitical factor that continues to cast its shadow, justifies taking a step closer to our scenarios, both in terms of the baseline (cuts in the second half of the year) and risk (no reduction in 2024). This seemed somewhat far-fetched at the start of the year, when the swaps suggested cuts of 150 basis points, but it has become more plausible after seeing how they’ve been reduced to the current range of 75-100 basis points.

In short, the approach seems more balanced in the short term, while failing to materialize imminent movements. Employment continues to reach record highs, despite structurally weak performance. However, a closer reading offers both a short-term shift and the fragmentation of a two-speed Europe. On the one hand, the Franco-German axis continues to raise concerns as to its ability to recover, with employment cooling and structural challenges settling into industry and, on the other, service-intensive countries, which remain a “crutch” for Eurozone growth.

Focusing more specifically on structural challenges, “the noise and signals generated by geopolitics continue to remind us that these are factors that should not be ignored,” explains MAPFRE Economic Research, particularly in the case of Europe, given its greater proximity to the Red Sea crisis and dependence in terms of exchange, which continues to worsen.

In terms of inflation, the latest data for February continued to show that the direction was correct. In fact, it’s the first time since the outbreak of the inflationary 'shock' that the forecast is once again in line with the target within the forecast horizon. However, the most recent data shows less promising progress in terms of this reduction, especially from the point of view of core inflation, demonstrating that central banks are coming towards a stage known as the “last mile.”

Therefore, evidence of this economic rebound may be seen in the coming months, while we might also see contrary negative indicators for inflation. Excluding energy and food (first-order inflationary elements in the most recent shock), goods inflation is still exposed to a mixed context in the manufacturing industry, which is more optimistic on the demand side, but subject to cost risks in supply chains on the supply side.

In turn, the services sector demonstrates that dynamism is not only maintained, but that the risk that the future evolution of salaries will lead to second-round effects does not remain far removed from the equation. What's more, and returning to the landing analogy that now seems outdated, it's likely that there is still some amount of monetary excess in the system that, to a certain extent, makes it difficult to reach a conclusion about the condition of the post-stimulus economy.

In short, the inflation thermometer will continue to be observed with some caution in the short term, keeping the appetite for lower interest rates at bay and raising the reputational benefit of the ECB (the need to revert to the process of cutting rates still has a higher cost than that of waiting too long), while continuing to offer “some safeguard” to the common currency (supply shocks cannot be controlled by monetary policy, but their effects can be eased).

The market's central assumption seems to be that we will see the conditions for this in June. However, it's not difficult to imagine the transition to a more patient alternative scenario in which “sacrificing growth” sustains more certain price stability.