Last month’s first-in-the-cycle US rate cut has not shifted the focus of investors and economists. On the contrary, every word from central bankers is scrutinised and can trigger a market reaction. This month, the European Central Bank (ECB) was seen turning ‘dovish ‘ this month, while the US Federal Reserve appeared keen to signal more rate cuts, but with caution.
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Less inflation means more rate cuts
In the eurozone, the consumer price index (CPI) for headline inflation came out lower than estimated at 1.7% year-on-year in September due to a lower contribution from energy. Core inflation was running at 2.8% and services inflation at 3.9% (after 4.1% in August).
This is still elevated in absolute terms. The persistence is explained by the cost of insurance, holiday packages, healthcare and rents – all components of services inflation.
Sticky services inflation – a component that is more directly linked to domestic demand and therefore more likely to react to monetary policy changes – did not prevent the ECB from cutting its three policy rates by 25bp on 17 October – as expected.
The central bank also adopted a dovish tone that paves the way for additional cuts. The pace of cuts could be faster than the once-a-quarter cut that is typical at the start of a rate cutting cycle.
Even though ECB President Christine Lagarde said during her press conference that ‘I didn’t open the door to anything’, she mentioned that inflation risks ‘are… perhaps more on the downside, at least compared with our forecasts’. Ms Lagarde acknowledged that there is ‘no question’ that at 3.25%, the deposit rate is still in restrictive territory.
It appears that ECB council members, who unanimously voted to cut rates this time, are now more focused on the future path of inflation than on the latest data. Ms Lagarde said several times that the results of surveys of future inflation trends had been taken into account during the recent discussions.
Poor growth prospects in the eurozone (and with a second year of GDP contraction in sight in Germany, according to government forecasts) are likely to weigh on prices and wages. This reinforces the likelihood of core inflation returning to the ECB’s 2% target sustainably.
The day after the latest policy meeting, the usual ‘sources’ said that some ECB governors would have liked to have dropped the commitment to keep policy tight. The governor of the Banque de France said that the ‘risk of inflation lastingly undershooting the target is now as big as overshooting it’. He added inflation should reach the target sooner than expected in 2025 and felt that any rebound in the European economy was far off.
What about fiscal policy in 2025?
Fiscal policy is expected to become more restrictive in some major European economies. In this regard, the International Monetary Fund (IMF) noted that ‘fiscal adjustment plays a crucial role in containing debt risks’.
In a recent article, presenting the analyses of the latest Public Finance Monitor, the IMF said that ‘with inflation moderating and central banks lowering policy rates, economies are better positioned now to absorb the economic effects of fiscal tightening. Delaying would be both costly and risky since the size of the correction needed increases as time goes by; and experience shows that high debts and a lack of credible fiscal plans can trigger an adverse market reaction, constraining any room to manoeuvre in the face of turbulence’.
The IMF analysis applies to many countries, including the US. To date, only a few major European economies have had to react to a worsening of their public finances. This looks less likely in the US.
Rather, it is worrying that the level of US federal debt has not been a topic in the election campaign.
According to June 2024 Congressional Budget Office forecasts, federal debt (at nearly 100% in fiscal 2024; see exhibit 2) would rise to 125% in 2033.
At the same time, a nonpartisan assessment of the two presidential candidates’ campaign platforms has concluded that implementing their proposed measures would significantly increase the debt compared to the CBO’s estimates.
Two different worlds
In conducting monetary policy, the ECB must take into account the prospects of inflation being under control and growth slowing as well as restrictive fiscal policy. This configuration may be driving the switch to a more dovish tone in ECB communications.
On the other side of the Atlantic, inflation also appears set to move towards 2% in 2025, but the Fed faces still dynamic growth. After solid retail sales in September, it appears personal consumption accelerated in the third quarter (from a 3.0% annualised increase in the second).
The Atlanta Fed estimate of real GDP growth in the third quarter, based on data as of 18 October, is now 3.4% annualised. That would ensure a carry-over effect of 2.7% on 2025 annual average growth after 2.5% in 2022 and 2.9% in 2023.
Comments from Fed officials in recent days have highlighted the resilience of the US economy and the need to be cautious about the pace of policy rate cuts. Their first goal was to remove expectations of a 50bp cut at the policy meeting on 7 November.
When the San Francisco Fed President emphasised recently that ‘compared to a recent history, the current expansion is still relatively young,’ suggesting that it is hard to imagine a reason that would cause a recession, does she want to push back expectations of lower policy rates?
The equation the Fed needs to solve is made harder by political unknowns. As mentioned, there is every reason to believe that fiscal policy will not turn restrictive if a president is elected who commands a majority in Congress.
The assumption of a faster decline in key rates in the eurozone than in the US is beginning to be reflected in the foreign exchange market, as shown by the acceleration of the fall in the EUR/USD exchange rate since the ECB’s latest policy meeting.
