ECB Case for Rate Caution Mounts as Fed Dot Plot Pares Back Cuts

(Bloomberg) -- European Central Bank officials just got another reason to hesitate over any further interest-rate cuts after the US Federal Reserve pared back its own plans for easing.

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With the so-called dot plots of officials in Washington now indicating only one reduction in 2024 instead of three previously, their peers in Frankfurt know that any further action on their part risks importing inflation via a potentially weaker currency.

ECB policymakers including President Christine Lagarde stress their independence from their US counterpart, as evidenced by their rate cut last week at a time when a Fed one wasn’t imminent. But they also know that monetary policy in the world’s largest economy exerts a gravitational pull that other central banks struggle to resist.

“The Fed decision will give the ECB hawks clearly some food for thought and will make them more cautious when it comes to additional rate cuts,” said Carsten Brzeski, head of macro research at ING.

That sense of wariness has been clear ever since the June 6 move to lower borrowing costs, a decision accompanied by higher inflation projections.

Traders pared back expectations of further action since then, and their view has stayed little changed since the Fed outcome. Money markets see a 60% chance of a quarter-point cut in September, but only a 40% chance of a further ECB move after that this year.

Most officials speaking since the Governing Council meeting have urged caution on further reductions in borrowing costs, highlighting huge uncertainty around the consumer-price outlook.

Lagarde herself said that rates are not on a “linear declining path” and that the ECB may leave them unchanged for more than one meeting in the future. Her colleague, Vice President Luis de Guindos, suggested that officials will tread carefully for the rest of the year.

“The Fed and ECB are running independent monetary policies, however we note that the lift of the dot plots by the Fed coincides with a more hawkish stance from the ECB,” said Piet Haines Christiansen, chief strategist at Danske Bank.

Some euro-area officials argue that a more aggressive easing for the 20-nation bloc could bring greater inflationary pressures — as lower borrowing costs relative to the US could weaken the single currency and pose an added risk via higher import prices.

Austria’s Robert Holzmann, the sole policymaker to oppose last week’s decision, reiterated this concern over the weekend.

But the overall effect of monetary-policy divergence is not clear cut. Tighter-than-expected Fed policy could also result in duly restrictive global financial conditions – leading to more of a dampening effect on the European economy with less pressure on prices.

In truth, many monetary officials across the advanced world know that easing in the US would at least offer them greater room for maneuver to do the same in their own economies if needed.

“The ECB and BOE would love them to cut, for all their protestations of ‘independence’ from the Fed,” said Dickie Hodges, who manages the global dynamic bond fund at Nomura Asset Management. “The ECB has begun to cut rates but will be exceedingly cautious of moving rates significantly if the Fed is unwilling or unable to go along for the ride.”

Another reason to be wary is a recent uptick in euro-zone inflation, drawing comparisons to the US — fueling concern that the ECB could face similar impediments to the Fed in lowering rates. Labor markets are tight on both sides of the Atlantic.

In that respect, Wednesday brought at least some positive news in the US. New data there showed that a key measure of underlying inflation cooled for a second straight month in May, following elevated readings at the beginning of the year.

“The US inflation data suggested that there might be some easing of inflationary pressures in the offing,” said ING’s Brzeski. Even so, “all in all, US developments over the past two days have made clear that also in the euro zone, room for further rate cuts is very limited, for now.”

--With assistance from Aline Oyamada.

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