QNB Group expects ECB to cut interest rates by 150 base points by mid-2025

Doha, Qatar: In mid 2022, an unprecedented inflationary surge pressed the European Central Bank (ECB) to embark on its most aggressive monetary tighte...

Doha, Qatar: In mid-2022, an unprecedented inflationary surge pressed the European Central Bank (ECB) to embark on its most aggressive monetary tightening cycle to date. In less than a year and a half, a record sequence of ten consecutive rate hikes took the benchmark deposit rate to 4%, its highest historical point. Supply chain normalization and tight monetary policy succeeded in curbing inflation, bringing it down from its peak of 10.6%, to below the 2% target of the central bank, QNB said in its economic commentary.

With inflation under control, the ECB began the new phase of interest rate cuts in June this year, taking the benchmark deposit rate to 3.25%. Going forward, the ECB needs to cautiously calibrate the path of interest rates, as the balance of risks gives more weight to economic stagnation than to inflation concerns. Leading economic indicators, which refer to statistics that anticipate economic conditions, have underperformed relative to forecasts in recent quarters.

The Economic Surprise Index provides a formal measure of how data releases stand relative to expectations. During the first half of 2024, the index was pointing to a significant improvement in conditions. This recovery injected a moderate dose of optimism into the economic outlook. However, this optimism proved to be short-lived as the European bloc was unable to unshackle itself from the negative spiral shaped by stringent monetary conditions, weak external demand, geopolitical uncertainty, and the energy crisis. In our view, the current context will lead to a more aggressive monetary easing cycle than what is currently expected by the markets. In this article, we discuss the three main factors that support our views.

First, with prices already under control, there is now an increasing risk that inflation drops too far below the objective of the ECB. Furthermore, a deflation spiral is now becoming a conceivable, even if still not highly likely, threat on the horizon. A deflation environment is deeply detrimental to the economy, as households and firms delay expenditures and investment to benefit from lower prices in the future, generating a negative economic feedback loop. 

Second, financial conditions remain highly restrictive on the back of still-elevated interest rates and the steady retrenchment of the central bank balance sheet. The current deposit facility interest rate of 3.25% still implies a restrictive level for the real interest rate, which adjusts the cost of credit according to inflation. Similarly, although overall financial conditions have come down since their peak restrictive heights in October last year, they remain at levels previously seen only during the Global Financial Crisis and the European Sovereign Debt Crisis.  Furthermore, the ECB continues to revert the balance sheet expansion that was put in place during the pandemic, which is limiting the availability of credit.