The ECB is about to cut interest rates for the third time this year! Is the rapid interest rate cut cycle about to begin?

The ECB will cut interest rates for the third time this year at Thursday's meeting as policymakers say the risk of inflation is easing faster than expected.

The overall inflation rate in the Eurozone fell to 1.8% in September, which is already below the central bank's target of 2%. Core inflation fell to 2.7%, the lowest level in two and a half years.

These figures generally continued to decline after the ECB cut interest rates by 25 basis points in June and another 25 basis points in September. The ECB has cut the key interest rate — the deposit facility interest rate — from a record 4% to 3.5%.

Currently, the money market not only sets the interest rate cut for the ECB's October meeting at 25 basis points, but also expects the central bank to cut interest rates by 50 basis points at the last meeting in December.

Since the ECB's interest rate meeting in September, the market's expectations for faster easing have been rising due to a series of dovish statements from officials and lower than expected inflation data for countries in the Eurozone (including Germany). Bank of France Governor Francois Villeroy de Galhau said last week that interest rate cuts in October are “very likely” and that this move “won't be the last time.”

In an interview with Radio France Presse, Villeroy said, “Overcoming inflation is just around the corner,” and he pointed out that the inflation rate may fluctuate and rise.

ECB President Lagarde told European Parliament members at the end of last month that the latest developments have strengthened the central bank's “confidence that inflation will fall back to the target level in time,” and said he will consider this in October. Citibank analysts described this signal as a “shift” from Lagarde's September 12 message. At the time, she suggested that given the risk of inflation prospects, it would be more appropriate to cut interest rates “gradually”.

Even Bundesbank President Nagel, a well-known hawkish figure at the European Central Bank, said at the beginning of this month that the inflation trend is “good news” and that he is willing to discuss further interest rate cuts.

Weak growth

The continued slump in economic activity in the Eurozone and the Fed's decision to continue cutting interest rates by 50 basis points on September 18 have also raised expectations that the ECB will continue to cut interest rates.

Barclays strategists said in a report last Sunday, “Significantly weaker activity data and a faster anti-inflation process have had a direct impact on ECB communications and the market.”

According to consulting firm Kaitou Macro, the comprehensive purchasing managers' index, which measures service and manufacturing activity, showed that the Eurozone economy stagnated in the third quarter and grew by only 0.3% in the second quarter.

Jack Allen-Reynolds, Deputy Chief Eurozone Economist at KITU Macro, said last week that in addition to structural problems such as the decline in German industrial competitiveness, tight monetary policy is also hampering economic growth. This prompted him to predict that the ECB will cut interest rates this week and at every future meeting until the deposit rate falls to 2.5%.

He added that this expectation is also due to a cooling labor market and slowing wage growth, which will help reduce inflation in the service sector over the next few months.

The ECB lowered its forecast for the Eurozone's annual economic growth last month against the backdrop of weak domestic demand. Currently, GDP is expected to grow by 0.8% compared to the previous forecast of 0.9%.

Wording adjustments

Economists from Bank of America Global Research said in a report last Sunday that they expect the ECB to cut interest rates this week, but will not make major adjustments to its guidelines.

They said, “We believe this is the beginning of an accelerated trajectory of reducing interest rates to 2% by June 2025 and further down to 1.5% by the end of 2025. However, it is highly unlikely that the ECB will deliver any such message. Meeting by meeting decisions and data dependency are likely to remain firmly dominant, perhaps only embellished by verbal references to rising confidence that inflation will return to target.”

Holger Schmieding, chief economist at Belenberg, said Lagarde is unlikely to correct market expectations for December interest rate cuts at a press conference on Thursday. He predicted that when the ECB releases new staff forecasts in December, it will have to further lower its forecast for economic growth in 2024.

However, Schmieding also warned that the ECB is currently at risk of overreacting and easing monetary policy too quickly.

“Inflation should not be a major issue next year... However, we don't think this will continue in 2026 and 2027,” he said in a report on Monday.

He believes that once the Eurozone economic growth rate returns to normal next spring, wage inflation will rebound, as expected by the ECB, and stronger demand will enable enterprises to pass on higher costs to consumers. Schmieding said:

“If the ECB cuts deposit interest rates to well below 3% in 2025, it may have to raise them back to 3% in late 2026 or early 2027.”