The European Central Bank (ECB) is facing a critical juncture as it grapples with the need for lower interest rates to stimulate the region’s faltering economy. While there’s a consensus on the need for easing, the extent to which rate cuts can truly address the underlying issues remains a point of intense debate among policymakers.
Some officials advocate for swift and substantial rate reductions to encourage consumer spending and business investment. They argue that lower borrowing costs will alleviate financial burdens on households, making saving less attractive and spurring consumption. Similarly, cheaper credit could incentivize businesses, particularly in the struggling construction sector, to increase investment.
Others, however, caution against aggressive easing, asserting that the current economic woes stem from deeper structural issues beyond the reach of monetary policy. Challenges like high energy costs, persistent labor shortages, declining productivity, and waning competitiveness are cited as factors that rate cuts alone cannot resolve.
This divergence in opinion will significantly influence the trajectory of the ECB’s easing campaign, with a fourth consecutive quarter-point reduction in the deposit rate expected on Thursday. With inflation largely under control, investors anticipate that dovish arguments for further rate cuts will prevail in the coming year, potentially pushing borrowing costs into expansionary territory.
“Views in the Governing Council differ over how much of the current economic weakness is cyclical and how much is structural,” notes Holger Schmieding, chief economist at Berenberg. This debate hinges on whether the ECB should lower rates below the neutral rate, a level that neither stimulates nor restricts growth. The prevailing view is that the economic slowdown reflects a combination of both cyclical and structural factors, requiring the ECB to act, but acknowledging that rate cuts alone won’t provide a complete solution.
While the eurozone experienced unexpected growth in the third quarter, recent data suggest a weakening trend. External headwinds, including geopolitical tensions in Ukraine and the Middle East, along with potential trade disruptions stemming from political shifts in the US, further complicate the outlook. Internally, Germany, the bloc’s economic powerhouse, faces a potential second consecutive year of contraction and upcoming elections, while France grapples with political and budgetary uncertainties.
Proponents of aggressive easing, such as Italian central bank Governor Fabio Panetta, emphasize the urgency of stimulating sluggish domestic demand to prevent inflation from falling below the 2% target. Panetta hasn’t ruled out pushing rates into negative territory.
Conversely, more hawkish members like Executive Board member Isabel Schnabel argue that rate cuts may prove ineffective if aimed at addressing structural problems. She contends that lowering rates below neutral without accompanying structural reforms might not boost investment and could deplete valuable policy space needed to counter future shocks.
Adding to the complexity, Finland’s Olli Rehn points out that the distinction between cyclical and structural issues is often blurred. While acknowledging that monetary policy can’t solve long-term growth challenges, he argues that easing financial conditions can stimulate aggregate demand and investment, mitigating potential long-term damage from recent supply shocks.
Graph showing Euro Area Inflation
Current market expectations suggest the deposit rate, currently at 3.25%, will settle around 2%, a level considered neutral. However, markets anticipate a more aggressive easing cycle, potentially pushing rates a quarter-point below that level. The key question remains whether the ECB will venture below the neutral rate.
While officials like Francois Villeroy de Galhau of France haven’t dismissed the possibility of negative rates if growth remains subdued and inflation risks falling below target, Bundesbank President Joachim Nagel sees no immediate risk of inflation undershooting 2% to warrant such a move. This debate will dominate the ECB’s policy discussions in the coming months.
Most economists acknowledge the limitations of monetary policy in addressing deep-seated structural issues. They emphasize the need for a comprehensive policy approach that combines rate cuts with structural reforms and supportive fiscal measures. As Katharine Neiss, chief European economist at PGIM Fixed Income, puts it, “Rate cuts won’t magically solve all the structural problems. They need to come hand in hand with structural reforms, with complimentary fiscal policies. So, it really needs a unified, coherent policy package.” This coordinated approach is crucial to effectively address the complex challenges confronting the eurozone economy.
