December '23 ECB Preview: Bowing to the inevitable

Summary

• Inflation is falling hard and fast. By March next year, the ECB will have no excuse left not to cut rates. Expect the rate cut cycle to begin that month, starting with a 25bps cut.

• Markets have priced in about 200bps of cuts, which roughly mirrors the early 2000s rate cut cycle that coincided with a relatively mild economic downturn. Given the fact that the current economic downturn is still mild, and the fact that we come from extraordinarily high levels of inflation, the ECB probably won’t entertain rate cut increments bigger than 25bps (the ECB did cut by 50bps multiple times back then). The 200bps or so in cuts would bring the deposit rate broadly in line with the long-term neutral rate. The real short rate would be about zero. I would argue that this scenario lacks imagination. Meaning something completely different can happen.

• Other scenarios are possible too. For example, in a so-called stop-and go scenario, the ECB will only cut rates briefly, perhaps by 100bps. Economic growth, bank credit and inflation pick up vigorously on the back of easy financial conditions, forcing the ECB to end rate cuts before entertaining rate hikes.

• In another scenario, the ECB has ‘classically’ over-tightened. Something will break soon; we just don’t know what. With inflation and economic activity taking another leg down, the ECB is forced into an aggressive easing cycle that brings the deposit rate to 1 percent or lower.

• Before discussing the rate cut timing and scenarios in greater detail, I review the ECB’s recent raft of bad decisions, clumsy communication, and its obsession with its often comically wrong staff forecasts. Instead of relying on the forecasts, Lagarde & Co should take its cue from the inflation analysis produced by its own research department. That research showed that by the late spring, inflation had clearly peaked. Add to that the obviously weak and weakening economic outlook, there was no question where inflation was headed. Down, down and down. If President Lagarde tries to play it tough and dismiss the notion of rate cuts in the first half of 2024, she will end up looking just as ridiculous as she did in early 2022. Remember the December 2021 Governing Council meeting, when she repeated the line that rate hikes in 2022 would be “very unlikely?” President Lagarde, better bow to the inevitable.