ECB Policymakers Begin Debating Whether to Cut Rates Below Neutral

European Central Bank (ECB) policymakers have started discussing whether interest rates should be reduced enough to stimulate the economy, marking a potential shift from years of restrictive monetary policy.

Conversations with six sources this week revealed that although there is no consensus yet, the debate is underway, signaling a notable change in the ECB's policy discussions. This could eventually lead to rate cuts sooner and deeper than previously expected.

The ECB has been rapidly cutting rates throughout the year, with the aim of reaching a "neutral" setting—where monetary policy neither stimulates nor restrains economic growth—believing that this would stabilize inflation. However, some policymakers are now questioning whether this is sufficient, particularly given the deteriorating economic conditions in the eurozone and inflation falling below earlier forecasts. This has sparked concerns that inflation could undershoot the ECB's target, as it did for much of the decade before the pandemic.

While the group of policymakers advocating for deeper cuts remains small, it is growing.

They argue that the ECB has been too slow in responding to current economic conditions and that more significant rate reductions are needed to prevent inflation from dropping too low. There is also a push for the ECB to rethink its "meeting-by-meeting" approach to decision-making and to abandon references to restrictive rates, which would signal that it is taking downside risks more seriously.

"I think neutral is not enough," said a source with direct knowledge of the discussions. "That decision is still some time away, but the economy has been stagnating for two years, and there is no recovery in sight."

Gediminas Simkus, the head of Lithuania’s central bank and a member of the ECB’s governing council, was among the first to publicly address this concern. "If disinflation processes get entrenched… it’s possible that rates will be lower than the natural level. We’ve had that for decades," Simkus said earlier this week, referring to the term "neutral" as sometimes interchangeable with "natural."

The ECB declined to comment on the matter.

One of the challenges in the debate is that the neutral rate is considered "unobservable," leaving room for uncertainty about its precise level. "If you were to ask me today, ‘Where is it?’, the honest answer is, ‘I don’t know,’" said ECB President Christine Lagarde this week.

There are various estimates for the neutral rate. The International Monetary Fund (IMF) places it at 2.5%, while ECB watchers polled by the bank estimate it to be around 2.25%.

ECB staff believe it’s close to or just above 2%, and market pricing suggests it may now be below 2%. Some individual policymakers see even greater variation in these estimates.

A significant point of contention is that the difference between the highest and lowest estimates could equate to as many as three rate cuts. By comparison, the US Federal Reserve's median estimate for its longer-run neutral rate is seen at 2.9%, but, as with the ECB, there is wide variation around this figure, and some argue that the short-term median could be different.

The primary argument for cutting ECB rates below neutral is the eurozone's sluggish economic growth, with the anticipated recovery failing to materialize. This means that the ECB is currently restricting the economy more than it initially thought, and high interest rates are stifling demand. Without a growth rebound, domestic inflation is expected to slow, and the labor market could soften, further adding downward pressure on prices.

While Simkus remains one of the few policymakers openly discussing the possibility of sub-neutral rates, others have raised concerns about the risk of inflation falling too low. Mario Centeno, the governor of Portugal's central bank, has been consistently warning about this risk. "I see more risks in undershooting target inflation than the other way around," Centeno said this week, adding, "most of the risks that we see, the downside risks that we see right now in our projections, they are endogenous."

French central bank governor François Villeroy de Galhau also expressed concerns about inflation undershooting the ECB's target. "There is… a risk that inflation undershoots, especially if growth remains subpar," Villeroy de Galhau said this week. "We can see the expected soft landing, but not a further take-off."

None of the sources interviewed advocated for rate cuts larger than the ECB's current pace of 25 basis points per move, and they stressed that the decision on whether to go below the neutral rate is still months away. They acknowledged that the outlook could change by the time any decision is made. 

By fLEXI tEAM