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Axel Weber: The Danger of Premature ECB Rate Cuts

FRANKFURT – By embarking on a new cycle of interest-rate cuts now, the European Central Bank appears to be relying too heavily on flawed forecasts and ignoring economic and geopolitical realities. Faced with the risk of either cutting interest rates prematurely or maintaining an overly restrictive monetary policy, the ECB has not chosen wisely.

With inflation in the eurozone dropping from a peak of 10.6% in October 2022 to 2.6% in May 2024, the European Central Bank is optimistic that inflationary pressures will continue to ease. Its March projections show inflation averaging 2.3% in 2024, before falling to 2% in 2025 and 1.9% in 2026. Thus, the ECB is expected to cut its key policy rate, the deposit facility rate, from 4% to around 3.75% on June 6.

Markets foresee this as the first of many cuts that will substantially lower the ECB's policy rates over the next two years. The signaling effect and the timing of the move are indeed significant, because this marks only the fifth time since the ECB's inception (26 years ago) that it has initiated a new rate-cut cycle. But while a forward-looking monetary policy is commendable, it faces inherent limitations, particularly given the uncertainty of economic forecasts.

After all, predicting inflation beyond a one-year horizon is notoriously difficult, and this uncertainty has only increased in recent years. The ECB's own failure to address the recent surge of inflation in a timely and effective manner was partly owing to inaccurate forecasts. Model-based forecasts, by design, tend to revert to historical averages in the medium term, and history also suggests that long-term inflation projections often converge to the central bank's targets. Thus, the ECB's forecasts showing declining inflation are partly a result of historical bias.

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Posted: May 31, 2024 Friday 08:13 AM