The European Central Bank cut its key interest rate Thursday by a quarter point, moving ahead of the U.S. Federal Reserve as central banks around the world lean toward lowering borrowing costs — a shift with far-reaching consequences for home buyers, savers and investors.
The ECB cut its benchmark rate to 3.75% from a record high of 4% at a meeting of the bank’s 26-member rate-setting council in Frankfurt.
The ECB said in a statement that “price pressures have weakened, and inflation expectations have declined at all horizons,” allowing it to start loosening credit.
The bank warned however that “wage growth is elevated, and inflation is likely to stay above target well into next year.” It declined to signal how far or how fast it might cut, saying it would decide meeting by meeting.
Analysts say the quarter-point cut on Thursday would likely not usher in a swift series of further cuts as the bank waits to make sure inflation is under control while easing credit to help the economy.
While inflation at an annual rate of 2.6% in May is well down from peak of 10.6% in October 2022, the decline has slowed in recent months and inflation even ticked up slightly from 2.4% in April. Inflation in the services sectors, a broad category that includes everything from medical care and haircuts to hotels, restaurants and concert tickets, remains elevated at 4.1%
The move represents a switch from the onset of the inflation surge, when the Fed took the lead in tightening credit by raising rates starting in March 2022, sending mortgage costs higher but also boosting returns for savers with money in certificates of deposit or money market funds. The ECB started four months later.
Major central banks around the world now are leaning toward lowering interest rates. Canada cut rates Wednesday. Central banks in smaller economies have already cut rates, including in Sweden, Switzerland, Hungary and the Czech Republic.
The Bank of England’s policymakers are scheduled to meet on June 20, but it’s not clear whether the governing board will cut the rate from 5.25%. Japan, an economic outlier among the world big economies, has started raising rates after years of below-zero rates and low inflation.
Central bank benchmarks are a big deal for governments, companies, home buyers, investors and and savers. The benchmarks influence borrowing costs across the economy, so lower rates can mean lower mortgage costs and credit card charges for consumers. Lower rates also can boost stock prices and the value of retirement accounts since they lower returns on conservative holdings like bank accounts or certificates of deposit relative to stocks, and can mean stronger economic growth that will boost corporate earnings.
The ECB’s higher rates quashed a nine-year-long rally in eurozone home prices and slammed construction activity, which is highly sensitive to borrowing costs. Higher rates have also raised the up-front costs for building new renewable energy production, raising fears that high rates could slow Europe’s transition away from fossil fuels under the 2015 Paris climate accords.
The inflation surge in Europe was unleashed first and foremost by Russia cutting off most natural gas supplies to the continent, and by logjams in supplies of raw materials and parts as the global economy rebounded from the Covid-19 pandemic.
Although the eurozone was hit first and hardest by the Russian cutoff, the resulting energy price spike has now largely subsided and inflation fell to 2.6% in May, down from a peak of 10.6% in October 2022 and within range of the ECB’s goal of 2%.
As the central bank with the world’s dominant currency, what the Fed does spreads ripples far and wide. Lagarde has said however that “we are data dependent, we are not Fed dependent,” although ECB officials take into account economic conditions outside Europe, including the U.S. but also Japan and China.
Widening the rate gap between Europe and the U.S. could weaken the euro against the dollar by pulling more investment money out of the eurozone and into dollar holdings in search of higher returns. That would hurt the ECB’s inflation battle by making imports more expensive. But in practice the euro has actually strengthened recently — from US$1.06 in mid-April to its current level around US$1.09 — even though the ECB has telegraphed a rate shift for weeks.
The Federal Reserve faces a very different economy, one in which inflation was fuelled less by the Russian energy shock than by government pandemic recovery spending, and more robust growth fuelled inflation. The U.S. consumer price index is at an annual 3.4%, some way from the Fed’s goal, also 2%.
Fed Chair Jerome Powell has said the bank expects to cut rates this year from the current benchmark level of 5.25%-5.5%, but no change is expected at the Fed’s next policy meeting on June 11-12. With inflation cooling slowly in the U.S., economists and investors now increasingly expect only one or two cuts this year.
Rate increases combat inflation by making it more expensive to borrow in order to buy goods, lowering demand and taking the pressure off prices. But high rates also hold back growth, and that has been in short supply in the eurozone, where the economy has shown very little growth recently.
Growth in economic output has hovered just above and below zero for more than a year before a modest upbeat surprise in the first three months of the year, when gross domestic product rose 0.3% from the quarter before.
“While it is noteworthy that the ECB is forging well ahead of the U.S. Fed, the transatlantic difference in inflation and growth more than justifies this, in our view,” said Holger Schmieding, chief economist at Berenberg bank.