When will the European Central Bank start cutting interest rates?

If what goes up must come down, then the pressing question on the minds of many in Europe is: when will interest rates start to fall? For months, interest rates have been set at the highest level in the history of the European Central Bank.

Despite protests from eurozone policymakers, investors are betting that the central bank will cut rates fairly soon – possibly in April. Traders believe interest rates should fall because inflation has slowed significantly (it has been below 3 percent since October) and the region's economy is weak. By the end of the year, the central bank will have cut interest rates by more than 1 percentage point, which amounts to a cut of five to six quarter points, implying trading in the financial markets.

However, policymakers are trying to turn market opinion in the other direction and postpone expectations of interest rate cuts. Many members of the central bank's Governing Council are wary of declaring inflation too early, lest it rise above the bank's target of 2 percent.

On Thursday, the European Central Bank maintained this outlook. It kept interest rates steady, keeping the deposit rate at 4 percent, where it has been since September. The bank said interest rates were at a level that, “maintained for a sufficient duration, will make a substantial contribution” to reducing inflation to 2 percent in a timely manner.

Not now, but probably in the summer

Yet there has been a shift at the central bank. Just last month, Christine Lagarde, the bank's president, said interest rate cuts had not been discussed and stressed the need to be vigilant against inflation. But the new year brought a change in tone. And last week, Mrs. Lagarde said yes it is likely that rates could drop in the summer.

On Thursday, the bank noted in a statement that “underlying inflation,” which is used to measure domestic price pressures, continued its downward trend and that past rate hikes had an impact. “Tight financing conditions dampen demand, which helps reduce inflation,” the bank said.

Central banks must choose their words carefully to steer the markets because it matters what investors think. If traders start anticipating lower interest rates, they could move markets in that direction and ease financial conditions sooner than the central bank would like. That could potentially undermine efforts to contain the economy and slow inflation. This started happening in earnest late last year after the Federal Reserve indicated it would cut interest rates this year, roiling markets in the United States and internationally.

Postponing expectations

Policymakers have tried to postpone expectations of rate cuts until at least the summer, arguing that they will not have the necessary data, especially on wage growth, until their June meeting.

“The ECB will err on the side of caution,” says Oliver Rakau, chief German economist at Oxford Economics, as they fear they are wrong again on inflation after previously underestimating its strength .

Meanwhile, those who say inflation will continue to slow are confident that the economy will not experience any more major shocks. Attacks on commercial ships in the Red Sea have caused shipping prices to rise and analysts warn this could lead to a resurgence in inflation if the disruption continues for long and these cost increases are passed on to consumers.

Would you rather now than never?

On the other hand, data shows that inflation has fallen faster than the central bank had predicted. Headline inflation rose in December as some government support measures expired, but could fall below 2 percent in the fall, according to economists at Berenberg Bank.

The region's economy is also weak and not overheated. Germany, the bloc's largest economy, is sluggish after data showed its economy shrank 0.3 percent last year. Separate data published this week showed that demand for loans from businesses and households continued to decline across the eurozone.

But it is possible to look at this situation somewhat positively, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “It could have been much, much worse,” he said. The recession in Germany, for example, could have been significantly deeper, he added. “Inflation was a disaster,” he said. “It's not under control yet, but it's going in the right direction.”

If inflation falls below 2 percent, which could happen this year, “there is absolutely no need to implement tight monetary policy,” he added.

He expects the central bank to start cutting interest rates in June and cut them by a full percentage point in total by the end of the year. Other economists, including those at Goldman Sachs and Deutsche Bank, predict rate cuts will begin in April.

While there is debate about how soon and how soon interest rates will fall, most economists agree that ultra-low interest rates are a thing of the past.

“The very low interest rates we had seen before the pandemic are unlikely to return, said Oxford Economics' Mr Rakau, because there is a much greater need to borrow money to invest, especially in renewable energy and new technologies.