ECB rate cuts have further to go

It is widely anticipated that on 12 December the ECB Governing Council will reduce the deposit facility rate (DFR) by 25 basis points, bringing it to 3%. It is also apparent that monetary policy easing will continue in 2025 reflecting the forecast that inflation returns to the ECB’s 2% target and that GDP growth remains below potential. Short-term interest rate futures anticipate that the ECB will cut the DFR towards 1.75% by the end of next year (see Chart 1).

Chart 1. Eurozone 3-month interbank rate implied in futures contracts

It is interesting to assess what the minimum level of interest rates could be in this monetary policy cycle. Two elements are crucial to answering this question: the level of the neutral real policy interest rate, i.e. the one at which monetary policy neither restricts nor stimulates economic growth, and the inflation and growth expectations for the next few quarters.

The neutral real rate is not observable and we must rely on an estimate of its value. Opinions expressed by members of the ECB Governing Council point to a range between 0 and 0.5%. If inflation in the eurozone were to settle at the 2% target and GDP were to grow in line with potential, the DFR should be between 2% and 2.5%. Currently, the real interest rate in the eurozone is 0.8%, a level that is still restrictive although less so than in the recent past (see Chart 2).

Chart 2. Eurozone nominal and real short-term rates

However, inflation in the eurozone has been running at a pace below 2% for several months. Annualised quarterly changes in both headline and core inflation, which excludes energy and food prices, point to the possibility of inflation falling towards 1.5% in the first half of next year. The decline could be even more pronounced if, as suggested by business surveys, increases in services prices slow more than in recent months.

If so, a DFR level of 1.75% would be at the high end of the neutral range if not still moderately restrictive. The monetary policy stance would be excessively punitive for growth. The eurozone economy has disappointed since late 2022 and consensus among analysts is for GDP growth of around 1% in 2025, below potential for the third consecutive year (see Chart 3). Risks to this forecast remain on the downside due to political uncertainty in Germany and France - although the German elections could improve the medium-term growth outlook - the ongoing weakness of the Chinese economy, and the threat of tariffs by President-elect Trump.

Chart 3. Purchasing Managers’ Index composite and GDP growth

Weak growth suggests that monetary policy should be expansionary to avoid inflation falling significantly below the central bank's target. The real rate should therefore be negative.

If the data confirms this scenario and the ECB acknowledges the case for expansionary monetary policy, the DFR should probably be cut to at least 1.25%, around 50 basis points lower than what markets are pricing in.

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