Merlin Weekly Macro: The ECB faces the hardest interest rate challenge

Whatever else might be happening to make the world a less safe place, whether Ukraine and the NATO/Putin missile stand-off or the burgeoning Middle East crisis, this month the markets’ primary focus is on the central banks and interest rates.

Eurozone: interest rate cut #2

As widely expected, in September the European Central Bank (ECB) cut its interest rates by a quarter point (0.25%) for the second time in this new policy loosening phase which, for the eurozone, began in June with a pause in July. The key ECB deposit rate now stands at 3.5%.

ECB economists predict a calm outlook for eurozone inflation, currently at 2.2%, after the significant hiatus of the past three years. Here is what they had to say: “Staff see headline inflation averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026, as in the June projections. Inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates. Inflation should then decline towards our target over the second half of next year.” The strategy is to tread softly-softly, nothing too precipitous, proceeding with a series of small cuts towards the ECB’s mandated target to manage the eurozone economy to a target inflation rate of 2%.

The ECB: a monetary Wizard of Oz?

If only it were that simple. Monetary policy is as much a trick of confidence as it is a mechanical process, but no more so than in the eurozone. Compared with the US Federal Reserve and the Bank of England, the ECB’s job is considerably more difficult: it does not operate within a homogenous, fully-formed, coherent economic system in which the central bank and the national treasury can exercise a level of economic coordination. Instead, regardless of their individual circumstances, the ECB has to apply a blanket single interest rate uniformly to 20 eurozone member economies who have neither fiscal nor political union, who are often competing with each other economically (e.g. the most obvious rivals as manufacturers and exporters of capital goods being Germany and Italy) and whose only common bond is that they share the same currency and regulatory framework.

The inflation rate the ECB refers to is simply the average of those countries who are members of the eurozone (in fact the average annual inflation rates referred to above are an average of an average!); the latest reported national data shows the range of inflation rates: the Netherlands with 3.6% is the highest down to Latvia and Lithuania at the low end with 0.7%. While all 20 countries are perforce allocated the same nominal interest rate (i.e. today, 3.5%), individually they have differing ‘real’ interest rates when their respective national levels of inflation are subtracted: Latvia and Lithuania have a positive real interest rate of 2.8% while in the Netherlands it is a negative real interest rate of 0.1%. This means that Latvians and Lithuanians have a financial incentive to save cash by depositing it in the bank where they will see the value of their savings more than keep pace with inflation. Dutch savers on the other hand have no incentive at all: on the contrary, at the current rate of their own national inflation the real value of their savings will erode.

Among the EU leadership the fog begins to lift: “This is plain daft”

Of course this is all a nonsense; it is as incoherent strategically as it is illiterate economically. We have written on the subject many times in these columns, including last week under the heading “Should we be worried about German politics?”. But reading our mind (or last week’s column) perhaps the penny is finally dropping, even among die-hard supporters of the European project. This week, the EU ‘elite’ met for its biannual summit to discuss the state of the Union. Normally a self-indulgent, self-congratulatory affair, this one seems to have been riddled with anxiety and self-doubt. If the reports are accurate (the forum operates under Chatham House rules: limited, selected reporting and nothing attributable) this was a rare meeting of minds about Brussels’ almost complete lack of self-awareness of the extent to which the eurozone and the broader EU are locked in a self-imposed political and economic doom-loop. Among others expressing concern, Italy’s Georgia Meloni was the one who reportedly said that the EU is regulating itself into its own grave.

The path to fiscal union which would complement monetary union, having embraced political union as a pre-requisite (in a functional democracy, you cannot tax legitimately and sustainably without representation), is liberally littered with political landmines, gin traps and cowpats and many other unpleasant or painful impediments. Whether it reaches its destination is about political leadership. But without first recognising the problems, it has no chance. Perhaps this week’s summit has been the beginning of a political catharsis in the EU: like the alcoholic or the drug addict, the first step to rehabilitation and eventual recovery is being brave enough to admit to yourself that you’re already in a deep hole and you need all the help you can get to climb out of it.

The Bank is relevant but the Fed is important

Meanwhile, after that brief dive down the rabbit hole of EU politics, after the ECB’s cut all eyes turn to the Federal Reserve (Fed) and the Bank of England. The Bank began loosening its monetary policy when it reduced the UK Base Rate by a quarter-point on August 1ˢᵗ; the market is assuming no change in policy on 19th September, ‘pricing in’ only 22.2% chance of a quarter-point cut and 77.8% that the rate will remain at 5%; currently it is seen as a two-thirds likelihood of a quarter point cut in November. While the Bank’s decision is important domestically, to the international investment audience it is the Fed, which announces the day before, which is most obviously of greater consequence.

How do you like your landing, sir? Hard? Or soft?

The market’s recent preoccupation has been a growing sense that the US economy is slowing far quicker than the reported historic data would suggest. In particular, the forward-looking business confidence indicators in the manufacturing sector point to recessionary pressures, though in seeming contradiction new orders remain quite healthy. Last month, the Fed indicated that as well as inflation and aiming to achieve the 2% target, it was paying increasingly close attention to the other part of its mandate which is to maintain full employment. The US unemployment rate has exceeded 4% since May raising concerns of incipient malaise (economists regard 4% as ‘full’ employment with those remaining out of work but being of working age either not looking for employment, unable to work or regarded as unemployable). It is a curious paradox that late last year when the US economy was seemingly impervious to the brakes being applied through higher interest rates and wages were accelerating, Fed chairman Jerome Powell was quite prepared to push the unemployment rate up to take the steam out of the jobs market; now that joblessness is on the rise, he is worried.

Not everyone agrees with the prognosis that unless the Fed does something dramatic, the US is destined almost inevitably for an economic hard landing. Tensions among investors have been manifesting themselves in the bond markets where the government bond yield is the usual bellwether of sentiment about the future trajectory for interest rates. The key US 10 Year government bond yield was 4.7% at the end of April; by this week it had been as much as a full percentage point lower. The majority-held view a few months ago was that the Fed needed to begin loosening policy by cutting interest rates in the summer, with three or four quarter-point reductions by Christmas. The Fed declined to play (in fact, at the beginning of January, the market was ‘pricing in’ seven rate cuts in 2024; nearly nine months on we are yet to receive the first). Still not acting despite the ECB and the Bank of England beginning their own cutting cycles, more commentators were saying that the Fed needed to get cracking, it needed to make a splash, its first cut should be a half-point in September; as the holidays progressed, reflected in a sharply falling Treasury yield (the corollary of which is prices rising) the clamour increased for a sequential half-point cut to follow in November. However, following the most recent inflation data which shows core inflation (excluding fuel and food prices) still too high thanks to buoyant service sector prices, the new consensus seems once more to be that the Fed will start its own policy loosening cycle with a quarter-point cut next week.

Whatever it does, the Fed will not please everyone: if it fails to do anything at all again, it will be accused of being a tease, constantly dropping hints and then doing nothing, on which basis investors will lose faith in its judgement. A quarter-point cut will rile the hawks who believe that the Fed is being indolent, it should be taking robust action to prevent the economy needlessly crashing; for the doves who see a more benign outlook, a half-point cut will be interpreted as the Fed panicking and being pushed about, caving in to the voices which shout loudest that the wheels are falling off. And let us not forget the US election, now less than eight weeks away: despite the central bank being politically independent, no doubt Donald Trump will wail and gnash his teeth that the Fed is biased, reducing interest rates ahead of polling day is politically rigged to favour Kamala Harris. Powell should ignore the jibe: his job is to manage the economy regardless of who is running the government. If Trump wins the White House, whatever policy decision Powell makes he’s most likely to be out of a job in any case.

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