Eurozone CPI: Confirming the Rate Cut?
At its last meeting, the ECB kept rates unchanged, but left the door wide open for a potential rate cut when it meets again in September. Since then, data has generally been cooler than expected, allowing markets to price in as many as three rate cuts for the rest of the year. With the ECB scheduled to meet only three more times, that implies a rate cut at every meeting.
But, the markets, and the central bank, are data dependent. The trajectory might suffer some bumps along the way if the data doesn’t continue to support the current trend. Inflation is the most important metric to determine monetary policy, and the EuroZone will publish that in dribs and drabs through the final two days of the week. This could lead to increased volatility in the shared currency.
The Obstacles to Rates Following Inflation Lower
Since the whole point of raising interest rates is to get inflation down, once inflation is trending in the right direction, the logical step is to start cutting rates. But, there can be some things getting in the way, such as the risk of a higher inflation coming back. This is a problem faced by two other major central banks: The Fed and the BOE. The US and the UK have economies that are growing significantly faster than the shared European one.
A faster growing economy naturally creates inflationary pressure, and one of the mechanisms to keep inflation in line is to have interest rates in “restrictive” territory. That is, the high interest rates restrict economic growth to prevent inflation. This is the situation for the US and the UK, and could keep those central banks holding rates higher for longer than the market expects. Europe’s economy has been sluggish lately, meaning this isn’t so much of a risk, and therefore the ECB doesn’t have as many obstacles to bringing rates down.
What the Data Could Say
The inflation rate for the whole of the Eurozone isn’t published until Friday. But the market often reacts to the data from the largest economy, which is Germany. German CPI figures come out a day ahead, and typically set the tone for the market reaction. That is, as long as the reading for the whole economy comes in line with the expectations set up from the German data.
Germany will release its flash (or estimate) for August CPI on Thursday, where analysts are expecting inflation to continue its decline to 2.2% from 2.3% prior. Of course this is subject to revision with the final data in a couple of weeks, but the reaction from the market is basically as if this is the final reading. This would put it just a couple of decimals from the ECB’s target.
The Market Reaction
The data for the whole of the Eurozone comes out on Friday, and it’s expected to report a dramatic drop to 2.2% annual inflation from 2.6% prior. Partially this is due to base effects as a large energy cost increase from last year will roll off. The core rate, which excludes more volatile elements, is expected to remain relatively high but continue downward to 2.8% from 2.9% prior.
If the trend is maintained, then the market would likely feel comfortable with its current pricing of rate hikes and keep the Euro relatively weaker. A surprise to the upside might not change expectations for September, but it could swing the rate of decrease, with investors moving to price in fewer cuts for the rest of the year. That could give the Euro a bit of a boost, particularly against the dollar where traders expect the Fed to cut four times this year.
