ECB may not cut again in Sep’24; has to follow Fed from Dec’24

·         EURUSD was also supported by the unexpected election win (final round) by the Macron-led center-left alliance in France against far-right Le Pen

On 18th July, some focus of the market was on the ECB’s monetary policy decision. As unanimously expected ECB kept all key policy rates unchanged; i.e. reference interest rates on the main refinancing operations (MRO-interbank rate) to +4.25%; interest rates on the marginal lending facility (MLF-repo rate) to +4.50%, and interest rate on deposit facility (DRF-reverse repo) to +3.75%. ECB kept rates on hold in July’24 after cutting rates in June’24. ECB’s MRO-interbank rate (REVERSE REPO) rate was at +4.75% in Mar’2001 and +4.25% in Sep’2008 followed by some financial crisis due to higher borrowing costs.

ECB said some inflation indicators rose in May due to temporary (transient) factors, but most stabilized or fell in June. High wage growth's inflationary impact has been mitigated by higher business profits, and monetary policy remains restrictive. Despite this, domestic price pressures and services inflation are still high, with overall inflation expected to stay above target into next year. The Council aims to return inflation to 2% and will maintain restrictive policy rates as needed. Decisions on rates will depend on ongoing economic data, underlying inflation trends, and the effectiveness of monetary policy. The ECB Governing Council (GC) is flexible and will adjust rates based on evolving data, without committing to a fixed path.

Full Text of ECB statement: Monetary policy decisions: 18th July’24

“The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports the Governing Council’s previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above the target well into next year.

The Governing Council is determined to ensure that inflation returns to its 2% medium-term target promptly. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

Key ECB interest rates

The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 4.25%, 4.50%, and 3.75% respectively.

Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP)

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Eurosystem no longer reinvests all of the principal payments from maturing securities purchased under the PEPP, reducing the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, to counter risks to the monetary policy transmission mechanism related to the pandemic.

Refinancing operations

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its 2% target over the medium term and to preserve the smooth functioning of monetary policy transmission. Moreover, the Transmission Protection Instrument is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate.”

Text of the opening statement by ECB President Lagarde: 18th July’2024

“The Governing Council today decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports our previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above our target well into next year.

We are determined to ensure that inflation returns to our two percent medium-term target promptly. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. We are not pre-committing to a particular rate path.

The decisions taken today are set out in a press release available on our website.

I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions.

Economic activity

The incoming information indicates that the euro area economy grew in the second quarter, but likely at a slower pace than in the first quarter. Services continue to lead the recovery, while industrial production and goods exports have been weak. Investment indicators point to muted growth in 2024, amid heightened uncertainty. Looking ahead, we expect the recovery to be supported by consumption, driven by the strengthening of real incomes resulting from lower inflation and higher nominal wages. Moreover, exports should pick up alongside a rise in global demand. Finally, monetary policy should exert less of a drag on demand over time.

The labor market remains resilient. The unemployment rate was unchanged, at 6.4 percent in May, remaining at its lowest level since the start of the euro. Employment, which grew by 0.3 percent in the first quarter, was supported by a further increase in the labor force, which expanded at the same rate. More jobs are likely to have been created in the second quarter, mainly in the services sector. Firms are gradually reducing their job postings but at high levels.

National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. Effective, speedy, and full implementation of the Next Generation EU program, progress towards capital markets union and the completion of banking union, and a strengthening of the Single Market are key factors that would help foster innovation and increase investment in the green and digital transitions. We welcome the European Commission’s recent guidance calling for EU Member States to strengthen fiscal sustainability and the Eurogroup’s statement on the fiscal stance for the euro area in 2025. Implementing the EU’s revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis.

Inflation

Annual inflation eased to 2.5 percent in June, from 2.6 percent in May. Food prices went up by 2.4 percent in June – which is 0.2 percentage points less than in May – while energy prices remained essentially flat. Both goods price inflation and services price inflation were unchanged in June, at 0.7% and 4.1% respectively. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June.

Domestic inflation remains high. Wages are still rising at an elevated rate, making up for the past period of high inflation. Higher nominal wages, alongside weak productivity, have added to unit labor cost growth, although it decelerated somewhat in the first quarter of this year. Owing to the staggered nature of wage adjustments and the large contribution of one-off payments, growth in labor costs will likely remain elevated over the near term.

At the same time, recent data on compensation per employee have been in line with expectations and the latest survey indicators signal that wage growth will moderate over the next year. Moreover, profits contracted in the first quarter, helping to offset the inflationary effects of higher unit labor costs, and survey evidence suggests that profits should continue to be dampened in the near term.

Inflation is expected to fluctuate around current levels for the rest of the year, partly owing to energy-related base effects. It is then expected to decline towards our target over the second half of next year, owing to weaker growth in labor costs, the effects of our restrictive monetary policy and the fading impact of the past inflation surge. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2 percent.

Risk assessment

The risks to economic growth are tilted to the downside. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia’s unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted.

Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected.

Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly.

Financial and monetary conditions

The policy rate cut in June has been transmitted smoothly to money market interest rates, while broader financial conditions have been somewhat volatile. Financing costs remain restrictive as our previous policy rate increases continue to work their way through the transmission chain. The average interest rate on new loans to firms edged down to 5.1 percent in May, while mortgage rates remained unchanged at 3.8 percent.

Credit standards for loans remain tight. According to our latest bank lending survey, standards for lending to firms tightened slightly in the second quarter, while standards for mortgages eased moderately. Firms’ demand for loans fell slightly, while households’ demand for mortgages rose for the first time since early 2022.

Overall, credit dynamics remain weak. Bank lending to firms and households grew at an annual rate of 0.3 percent in May, only marginally up from the previous month. The annual growth in broad money – as measured by M3 – rose to 1.6 percent in May, from 1.3 percent in April.

Conclusion

The Governing Council today decided to keep the three key ECB interest rates unchanged. We are determined to ensure that inflation returns to our two percent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. We are not pre-committing to a particular rate path.

In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission.

We are now ready to take your questions.”

Highlights of ECB policy and President Lagarde’s comments during Q&A (Presser): 18th July’2024

·         ECB Interest Rate Actual 4.25% (Forecast 4.25%, Previous 4.25%)

·         ECB leaves key rates unchanged in July monetary policy decision, as expected

·         ECB Deposit Rate Actual 3.75% (Forecast 3.75%, Previous 3.75%)

·         The ECB will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim

·         Incoming information broadly supports the governing council’s previous assessment of the medium-term inflation outlook

·         The governing council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner

·         The governing council is not pre-committing to a particular rate path

·         It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim

·         The ECB will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction

·         Eurosystem no longer reinvests all principal payments from maturing securities purchased under PEPP, reducing PEPP portfolio by €7.5 billion/month on average

·         In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, dynamics of underlying inflation and strength of monetary policy transmission

·         APP and Pandemic Emergency Purchase Programme (PEPP) APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests principal payments from maturing securities

·         ECB intends to discontinue reinvestments under PEPP at the end of 2024

·         ECB will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, to counter risks to monetary policy transmission mechanism related to pandemic

·         Wages profits & geopolitics are upside inflation risks

·         Risks to growth are tilted to the downside

·         HICP is to decline to target in H2 next year

·         Risks to growth are tilted to the downside

·         Inflation is to fluctuate near the current levels for the rest of the year

·         Recent data on compensation is in line with expectations

·         Surveys suggest profits should be dampened in the near term

·         Growth in labor costs will remain elevated in the near term

·         Wages are rising at an elevated rate

·         Domestic inflation remains high

·         More jobs were likely created in Q2, mainly in services

·         The labor market is resilient

·         I expect recovery to be supported by consumption

·         Services lead recovery, industry, and exports are weak

·         Investments point to muted growth in 2024

·         Incoming data indicates that the economy grew in Q2

·         We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction

·         Domestic price pressures are still high

·         Headline inflation is likely to remain above the target well into next year.

·         Most inflation measures are stable or edged down in June.

·         So the question of September and what we do in September is wide open and will be determined based on all the data that we will be receiving. Our projection from June will be a point of reference, but the projection for September plus all the other elements that we will be receiving will be taken into account to decide what we do in September. But there is no predetermined path and that was very strongly endorsed by the Governing Council.

Customary ECB Sources (after ECB meeting):

·         ECB officials consider if only one more cut is feasible in 2024

·         Policymakers are increasingly concerned that they will only be able to cut interest rates once more this year

·         With inflation pressures still high, officials are losing confidence that a path for two more reductions is feasible, and they don't want investors to believe that a move in September is a done deal.

Conclusions:

In June’24, the annual Euro Zone Core CPI (w/o energy, food, alcohol, and tobacco) was around +2.9%, unchanged sequentially, after a consecutive decline from recent top +5.7% in Mar’23 amid lower oil/energy prices.

The 6M and YTM rolling average of EZ Core CPI is now around +3.0% against the +5.0% average in 2023, while the YTM sequential (m/m) rate is now around +0.4%; i.e. annualized rate is almost around +4.8%.

The EZ service inflation has also stuck around +4.0% for the last 6 months on average, still quite elevated against pre-COVID levels of +2.0%.

The EZ real GDP growth is around +0.4% in 2023 (y/y) against an average of 1.7% in 2018-19 (pre-COVID). The trend rate of EZ real GDP growth should be around +2.0%. In Q1CY24, the EZ real GDP growth was around +1.3% (y/y), while the average unemployment rate was around 6.5%. Overall it’s a stagflation-like scenario for the Eurozone economy due to excessive fiscal austerity, and lower productivity, almost half of the US; average pre-COVID EZ unemployment rate of around 7% is almost double that of the US even after some fiscal measures to suppress the actual unemployment in EZ, which may be around double-digit, if correctly measured.

As per Taylor’s rule, for the Eurozone:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.0-2.00) =0+2+3.0=5.0%

Here for EU /ECB

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= Estimated average core inflation=5.0% (for 2023~4.95%)

The repo rate of the ECB is now at +4.50% against Taylor’s rule suggestion of +5.0%. Even if we adjust the -1% real GDP output gap (2023 growth around +0.4% against potential/desired run rate 1.50-2.00%), the desired repo rate for 2024 should be around +4.00%. Growing real policy divergence between the Fed and ECB along with a stagflation-like scenario in the EU is keeping EURUSD under stress, causing more imported inflation as the EU depends on both fuel and food imports. Thus despite the ECB narrative of translantic divergence and one symbolic rate cut of -25 bps in June for domestic political/election compulsion, in the longer term, the ECB may have to follow the Fed in real policy action, whatever may be the narrative.

Bottom line:

Looking ahead, ECB may further cut from Dec’24 after pausing in Sep’24 in line with Fed.

Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.0900) now has to sustain above 1.09500 for any further rally to 1.10000* and 1.11500/1.11800-1.12500/1.13000* and 1/14500-1.17400 in the coming days; otherwise sustaining below 1.09300, may again fall to 1.08600/1.07900-1.07700/1.06700 and 1.06000/1.05300/1.05000* and even 1.0000/0.95000 in the coming days (in case ECB goes for further rate cuts despite Fed being on hold).