The EU this week became the second major world economy to cut lending rates, citing progress in combating inflation.
The European Central Bank (ECB) announced that it will cut its main interest rate from a record high of 4% to 3.75%.
This follows Canada’s decision on Wednesday to lower its official lending rate.
The ECB’s move comes as voters head to the polls in an EU-wide election over the next four days, with results expected to reflect people’s dissatisfaction with the squeeze on the cost of living.
ECB President Christine Lagarde said the inflation outlook had improved “significantly”, paving the way for interest rate cuts.
But he warned that inflation was likely to remain above the central bank’s 2% target “for the rest of next year,” averaging 2.5% in 2024 and 2.2% in 2025.
He said the ECB would “continue to maintain a sufficiently restrictive interest rate policy for as long as necessary” to bring inflation down to the central bank’s 2% target.
However, he added, “We are not committing to a specific interest rate path in advance.”
Lindsey James, investment strategist at Quilter Investors, said the rate cut was widely expected but would still be a relief to consumers and businesses on the continent.
“The ECB has stolen a march on the Bank of England and the (US) Federal Reserve (both of which could still be months away from cutting interest rates) to inject some life into an economy in desperate need of some form of stimulus. “It will be,” he said.
Central banks have kept interest rates high for the past two years to curb price increases, with most targeting annual inflation of 2%. However, rising interest rates tend to slow economic growth.
Lower interest rates should make it cheaper for consumers and businesses to borrow money, spurring economic activity.
The EU’s rate-setting body decided to cut interest rates at a meeting in Frankfurt on Thursday, despite a slight rise in inflation in May. Inflation in the 27-nation bloc rose to 2.6% from 2.4% in April.
The ECB’s decision follows Canada’s rate cut on Wednesday, which cut the headline rate from 5% to 4.75% after the country’s inflation rate fell to 2.7%. Sweden and Switzerland also lowered interest rates.
Largarde gave a wide-ranging assessment of the eurozone’s economic outlook. She said: “There is an overall increased confidence in the path ahead because we have to look forward.”
But she also warned of the “difficult road” the region could face in the future.
“Risks to economic growth are balanced in the short term, but remain tilted to the downside in the medium term,” he said, citing conflicts in Ukraine and the Middle East.
He warned that geopolitical tensions could weigh on growth, while extreme weather events and the broader climate crisis could push up food prices.
However, Catherine Nice, chief European economist at investment firm PGIM, said she was “quite confident” that the ECB would cut further interest rates over the summer and autumn, resulting in euro zone interest rates below 3.5% by the end of the year. “There is,” he said.
“Growth is encouragingly recovering from the recession the eurozone experienced at the end of last year, but it remains weak,” he told the BBC’s Today programme.
This factor, combined with slower inflation and slower wage growth, would justify further rate cuts, he said.
Interest rates in the UK have not yet begun to be lowered, but there are speculations that the Bank of England may do so as soon as this month.
UK inflation has fallen to 2.3%, well below its peak of over 11% in late 2022.
Last month, the International Monetary Fund proposed that the Bank of England should cut interest rates to 3.5% from the current 5.25% by the end of next year.
But Polar Capital’s George Godber said the upcoming UK election would “complicate” the Bank of England’s next decision on June 20.
Mr Godber said that while the central bank was politically independent, the Conservative government had made lower interest rates part of its promise to voters, which could influence its “mindset”.
“If you cut it, it becomes political, and if you don’t cut it, it becomes political,” he said.
The US Federal Reserve is also expected to cut interest rates in the coming months, although the latest US inflation rate is even higher at 3.4%.
Godber said the Fed is likely to take its first action on interest rates just before the November vote.
