The data shows the ECB must cut faster

Data out of Europe over the past few weeks has pointed to both lower growth and lower inflation, and rate expectations have shifted accordingly with market pricing now implying a 96% chance of another 25bp cut from the European Central Bank (ECB) on October 17, up from around 25% on September 20. The ECB’s cutting cycle has so far been slow and steady, with an initial 25bp cut in June followed by a pause in July and another 25bp cut in September. The question for the market now, however, is whether these recent data prints are enough for the ECB to increase the pace of cuts going forward (i.e. go meeting by meeting), or whether they should be considered noise that can largely be ignored.

First, what is the data telling us? Since the ECB’s last meeting on September 12, we have seen updated Purchasing Managers Index (PMI) and Consumer Price Index (CPI) data from the Eurozone. After a strong uplift in August from the Paris Olympics, the September reading of Eurozone composite PMI was well below forecast at 48.9. Even after being revised on Thursday to 49.6, this is the first print below 50 (showing contraction) since February. One data print does not make a trend, and the ECB will be focused on evaluating the data as a whole; the average monthly composite PMI reading over the third quarter was 50.3, lower than the 51.6 average in the second quarter but much higher than the 47.5 average across Q3 2023, when real GDP growth in the Eurozone was 0.0% quarter-on-quarter (QoQ).

The important thing for markets is not necessarily understanding the trend, but how it affects the reaction function of the ECB. Of course, the ECB does not have a growth mandate, but it does release staff projections once a quarter which will feed into the discussion around monetary policy decisions. At the September meeting the central bank downgraded its estimates for real GDP growth by 10bp to 0.8% in 2024 and 1.3% in 2025. Built into these assumptions are a quarterly real GDP “run rate” for the remainder of the year of 0.2% QoQ, a step down from the 0.3% level in Q2 but still stronger than in 2023. We see some downside risk to the ECB’s estimate of real GDP growth this year, but only marginally so given the data we have so far.

Outside of growth activity, what will be important for the ECB’s October 12 decision is the recent trend in inflation. Harmonised CPI inflation in France plummeted on a month-on-month basis in September, at -1.2% versus an expected -0.7%, pulling the year-on-year (yoy) rate down to 1.5% (well below the expected 1.9%). There was a similar trend in Spain (-0.1% vs. 0.1% expected leading to a yoy rate of 1.7%) and Germany (0.0% vs. 0.1% leading to a yoy rate of 1.6%), while Italian CPI came in line with expectations though at the lower yoy rate of 0.8%. Headline CPI for the Eurozone as a whole came in at 1.8% yoy. Base effects for energy are expected to get worse in Q4, which will likely take the headline rate higher into year-end, but it will likely be lower than the ECB’s 2.5% staff projection just a few weeks ago.

The more important measure for the ECB will be core inflation, given the influence of energy prices in the headline print above. There is no doubt that core remains stickier than headline, as we have seen for a few years now, but core ticked down 10bp to 2.7% in September. Services CPI, which has been the driver of the sticky core prints, declined from 4.2% to 4.0%.

Importantly, that 2.7% core print is also below the ECB’s staff projection of 2.9% for the full-year 2024. Given a 2025 forecast of 2.3%, this implies a reasonable probability that core inflation could reach the ECB’s 2% target at some point next year. We think this alone should spur the governing council to cut in October, but the recent weakness in growth indications should help the more hawkish members along too.

Market pricing of ECB cuts has shifted lower over the course of the past week. Not only are markets now pricing in around 61bp of cuts for the remainder of 2024, implying a 44% probability of at least one 50bp cut this year, but they are also pricing in a terminal rate of approximately 1.6%. Both of these things are not out of the question. We believe the neutral rate is around 2% (0% real), so if inflation continues to decline in this backdrop of sluggish growth, it would make sense for the ECB to cut rates below 2% in order to become accommodative. That said, there are a few things that make a 50bp cut this year unlikely in our view. First, core inflation remains well above the ECB’s target and an expected decline in wage growth next year might not materialise to the degree the ECB is hoping. Second, real GDP growth should still be supported by a tight labour market (the Eurozone has record low unemployment rates) and solid real income growth. And third, base effects on the headline inflation rate should turn less favourable in Q4, pushing the rate higher into year-end.

Ultimately, we do think the ECB needs to cut more consistently than it has been. As we have argued for the US, the first 150bp are a “no-brainer” even if one assumes a slightly higher neutral rate than pre-Covid. Going too slowly risks unduly damaging the economy, which is more precarious in the Eurozone than it is in the US, even given the unemployment trends in the US. To us that suggests cutting at 25bp per meeting for the foreseeable future, but with a direction of travel that could see pressure build for more rather than fewer cuts given how the economic data is developing.