In December, the European Central Bank basically announced the end of the current rate hike cycle. Financial markets took that signal and the current economic weakness as clear signs of imminent rate cuts. However, even if real growth continues to be weaker than the ECB expected each quarter, as long as the eurozone remains in de facto stagnation mode and does not fall into a more severe recession – and as long as the ECB continues to predict a return to potential growth rates one or two quarters later; there is no reason for the central bank to react. Certainly not while inflation remains off target.
The irony of market pricing right now is that it makes the need for real policy rate cuts less urgent. Financing conditions have eased since early December, doing the job that real rate cuts should do: supporting growth but also raising inflation risks. Consequently, the more aggressive the market prices future rate cuts, the less necessary and likely those cuts will be. At the same time, given the high degree of uncertainty surrounding the outlook for both growth and inflation, any more explicit guidance the ECB may give next week could easily be rendered obsolete by actual macroeconomic developments. Therefore, the most likely outcome of next week’s ECB meeting will be to emphasize data dependence and give some ideas about the potential conditions for a rate cut without pre-committing to anything.