Daniel Grizelj
Encouraged by recent economic data suggesting inflation might sustainably reach its 2% target next year, the European Central Bank (ECB) cut the deposit rate by 25 basis points to 3.50% but refrained from providing strong guidance on the future path of rates.
The September rate cut, the second this year after June, reaffirms the ECB’s projection of hitting the inflation target by the fourth quarter of 2025.
We believe the ECB is in no rush to cut rates but also does not want to keep rates too high for too long, given the weak growth picture. Given that domestic inflation remains elevated (largely reflecting persistent price pressures in the services sector), monetary policy will need to remain restrictive.
The ECB reiterated that decisions will be made on a meeting-by-meeting basis, with data over the coming months deciding the pace of removing restrictiveness.
We expect a third rate cut of this cycle in December, with market pricing implying a terminal rate of about 1.9% by the end of 2025, reflecting gradually diminishing “last mile” inflation concerns. We expect the ECB’s Governing Council to discuss the appropriate neutral policy rate configuration next year, when the policy rate falls below 3%
Contrary to our view at the start of this year, we now broadly agree with market pricing and see limited upside for European duration outside a recessionary environment, so our stance is broadly neutral.
As for the interest rate curve, we continue to expect the back end of the interest rate curve to underperform shorter maturities due to gradual rate cuts and rebuilding term premia.
New ECB projections suggest disinflation remains on track
For inflation to evolve in line with ECB expectations and durably converge to target in 2025, the key will be a slowdown in unit labour costs to 2%, driven by wage and productivity growth. Wage growth has been lower than expected, and forward-looking ECB wage trackers continue to signal a solid deceleration in 2025. While productivity remains weak, it is developing broadly in line with expectations.
The ECB’s quarterly wage index shows year-over-year wage inflation slowing from 4.7% in the first quarter to 3.6% in the second quarter. Similarly, compensation per employee in the second quarter was 4.3% compared with the year before, down from 4.8% in the first quarter.
On the productivity side, second quarter data suggest that labour productivity, per person, had fallen by 0.3% compared with the year earlier, in line with the staff macroeconomic expectations from June.
As it stands now, the September staff projections foresee a gradual recovery in productivity to around 1% over time, and the growth rate of compensation per employee declining from 5.3% in 2023 to 4.5% in 2024, 3.6% in 2025, and 3.2% in 2026.
Preliminary August headline inflation fell 2.2%, down by 0.4 percentage points from the year before, while core inflation edged 0.1 percentage points lower to 2.8% over the same period. Sequentially, the core pace was broadly unchanged, at about 3% in the last three months, with the theme of weak core goods inflation and stronger services inflation continuing.
Overall, the ECB maintained its medium-term inflation outlook, relevant to the final two years of its three-year forecast, unchanged at 2.2% in 2025 and 1.9% in 2026. Importantly, given low tolerance for projecting inflation to return to target only by 2026, the ECB continues to expect convergence in the fourth quarter of 2025.
The large MRO rate cut is of limited market relevance
The ECB has established the deposit facility rate as its primary tool for monetary policy, while the main refinancing operations rate (MRO) is the rate banks pay when they borrow money from the ECB for one week.
In line with its operational framework review in March, the ECB lowered the MRO rate in September from 50 to 15 basis points above the deposit facility rate, to 3.65%.
This adjustment aims to encourage banks to participate in weekly operations, so that short-term money market rates continue to evolve closer to the deposit facility rate.
However, euro area banks are not frequently using the ECB’s MRO rate for their short-term funding needs because liquidity conditions remain ample and the ECB’s short-term funding is considerably more expensive than any other form of money market funding. We expect this to remain the case even under the new, more favourable rate.
As a result, we do not expect widespread participation in the regular ECB tender operations until banks’ excess liquidity falls below a certain threshold, at which point ECB operations might become more attractive than other market options. Given projections for excess liquidity over the medium term, this inflection point will probably not be reached before 2027.
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