Possible ECB Rate Cut in December: Inflation on the Right Track

The European Central Bank (ECB) has been closely monitoring inflation trends, and President Christine Lagarde has recently expressed optimism about the direction of inflation. As the ECB considers a potential interest rate cut in December, it is essential to analyze the current inflation outlook and the factors influencing the ECB's decision-making process.



Inflation has been on a downward trajectory in recent months, with the annual rate falling from 2.6% in February to 2.4% in March, according to Eurostat's flash estimate. This decline is driven by lower food and goods price inflation, as well as moderating wage growth and firms absorbing part of the rise in labor costs in their profits. Most measures of underlying inflation have also eased, indicating a gradual reduction in price pressures.

The ECB's latest projections show a decline in headline inflation, with staff expecting an average of 2.4% in 2024, 2.1% in 2025, 1.9% in 2026, and 2.1% in 2027 when the expanded EU Emissions Trading System becomes operational. For inflation excluding energy and food, staff project an average of 2.9% in 2024, 2.3% in 2025, and 1.9% in both 2026 and 2027. These projections suggest that underlying inflationary pressures are easing, supporting the ECB's decision to cut interest rates.

Wage growth has been elevated but is expected to moderate over the course of next year. 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 course of next year. This moderation in wage growth is likely to help reduce unit labor costs, which have been high in part due to weak productivity growth.

Inflation expectations, both market-based and survey-based, have been trending lower in recent months. Market-based inflation expectations, as measured by the five-year, five-year forward inflation-linked swap rate, have been declining, reflecting a more dovish stance by the ECB and a lower expected path for interest rates. Survey-based inflation expectations, such as those collected by the ECB's Survey of Professional Forecasters, have also been trending lower, with the median inflation expectation for 2024 falling to 2.2% in the latest survey.

The ECB's commitment to a data-dependent and meeting-by-meeting approach means that the timing and magnitude of any potential interest rate cut in December will be determined by the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. This approach allows the ECB to remain flexible and adapt its monetary policy decisions to the evolving economic situation.

In conclusion, the ECB's updated inflation outlook, including core inflation and wage growth, supports the possibility of an interest rate cut in December. The ECB's commitment to a data-dependent and meeting-by-meeting approach ensures that the final decision will be based on the latest data and developments. As inflation continues to move in the right direction, the ECB may choose to cut interest rates to support the economic recovery while maintaining its two per cent medium-term inflation target.