ECB Interest Rates

At our meeting yesterday, the ECB’s Governing Council cut our three policy rates by 25 basis points (or, one quarter of a percent).

The disinflation process remains on track, allowing us to reduce rates. However, with some components of inflation still too high for comfort – notably, services inflation – I continue to favour a gradual reduction in rates over large moves. 

As policy rates fall, we should see a reduction in the costs of borrowing for households and firms.   We are already seeing signs that the costs of financing in Ireland are easing since the end of interest rate rises in September 2023. 

Inflation

Our latest projections for the euro area show inflation returning to 2 per cent during 2025. This is despite the recent pick-up in inflation, which we fully expected, as the annual energy price falls we saw from the end of 2023 fall out of the index.

While food inflation is somewhat higher than expected, the latest data show that all other components are below our projections from September.  

A note on food inflation. Food is a significant component of household spending, some 16% for the average Irish household and even larger for lower-income groups (PDF 237.71KB).  Increasing food inflation in recent months, to around 3%, is largely due to increased commodity prices following adverse weather. Given the outlook for commodity prices, we expect food inflation to peak at around 3.2% in mid-2025, before gradually returning to the long-run average of 2%.

Much like energy prices, global supply and demand developments influence food inflation so it is less sensitive to ECB monetary policy that targets conditions in the euro area. This is why we pay close attention to core inflation measures, which exclude food and energy.

Services makes up around two-thirds of core inflation, with goods inflation accounting for the rest. Services inflation is taking longer to fall back to pre-pandemic norms, hovering around 4% in the euro area for all of 2024.  As I have previously said, with goods inflation around its long-term average of 0.5-1%, I want to see services inflation closer to 3% in order to be more in-line with our target.  The ongoing easing of wage pressures in the euro area should help with this.

Economic growth

The picture for euro area economic growth is more mixed. The better-than-expected data for the third quarter – in part from a one-off Olympics boost – offset some of the underlying weakness.

There are also significant cross-country differences, with countries that are more reliant on manufacturing facing weaker growth prospects.

We expect consumer spending to be main driver of growth in the near-term, supported by wage growth and falling inflation (rising real wages). There are risks to this narrative: forward-looking sentiment indicators point to a lack of confidence amongst households in the euro area, and employment prospects for manufacturing firms in particular could also weigh on growth. This hesitancy has resulted in higher-than-usual savings rates in recent quarters.

Indeed, we have incorporated a slight cut to our forecasts for economic growth to reflect these factors. Despite this, our baseline projection is that growth will strengthen next year as the rise in incomes support increased spending and investment. However, the economic outlook remains subject to a lot of uncertainty. In particular, a rise in geopolitical tensions – from ongoing conflicts or a change in the environment for international trade – could have adverse effects for the euro area economy.

The Irish Economy

The same, of course, is true of the Irish economy. Yet the underlying conditions are quite different here, with a steady pace of growth in 2024 giving rise to concerns over potential infrastructure bottlenecks that constrain sustainable growth. Inflation pressures have nevertheless waned substantially throughout the course of the year.

We will publish our updated forecasts in our Quarterly Bulletin next week.

Conclusion

Yesterday’s decision to lower rates was based on an updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission.  My colleagues and I on the ECB’s Governing Council are determined to ensure that inflation stabilises sustainably at our 2% medium-term target.  Although we have not committed to a particular rate path, the direction of travel on interest rates is clear. The exact pace and number of further reductions depends on inflation outturns continuing to move in line with our projections, as well as wider developments in the euro area economy.   

As the short-run outlook for inflation becomes more stable, the attention of monetary policy makers will return to medium-term considerations. In this vein, the factors that affect economic growth, which I highlighted recently, will come to the fore in future policy debates.

I plan to return to these issues in 2025.  In the meantime, next week’s Quarterly Bulletin will include a discussion of some of the risks facing us in the near term, as well as our assessment of the long-term growth prospects for the Irish economy.   

Gabriel Makhlouf