Navigating the ECB's new monetary policy: Implications for Spain and beyond
Wednesday, 31 July 2024
In a recent episode of the "Future is Blue" podcast, Carlos Carnicero Urabayen sat down with Alice Faibishenko, Senior Advisor at Funcas, to discuss the latest developments in the European Central Bank's (ECB) monetary policy. The conversation covered the ECB's recent rate cut, contrasting approaches with the U.S. Federal Reserve, and the broader implications for financial markets, financial sectors, and households and firms, particularly in Spain. You can listen to the podcast here.
ECB's rate cut: A long-awaited move
On June 6th, the ECB took a significant step by cutting its three key interest rates, marking the first rate cut in a prolonged period. This decision, largely anticipated by the markets, saw the rate on main refinancing operations reduced by a quarter of a point to 4.25%. The move signalled the ECB's growing confidence in inflation dynamics, though the bank held rates steady in its July meeting, leaving future decisions open to incoming data.
The ECB had been hinting at this cut for some time, preparing the markets for a shift in policy. According to Faibishenko, the reduction in rates came after careful consideration of the inflation outlook, which has shown signs of easing. However, the ECB also acknowledged persistent internal inflationary pressures, particularly from wage growth, which remains robust. This balance of factors led to a cautious approach, with the central bank signalling that future rate cuts would be data-dependent.
Divergent paths: ECB vs. Federal Reserve
The discussion highlighted the contrasting approaches of the ECB and the U.S. Federal Reserve. While the ECB's decision was influenced by a perceived easing of inflationary pressures, the Fed maintained its target rate, emphasizing a cautious stance until more substantial evidence of controlled inflation emerged. This divergence underscores the complexity of global monetary policy and its varied impacts on economies.
Faibishenko explained that the Fed's reluctance to cut rates stems from its commitment to ensuring inflation is firmly on a downward path. Despite some improvements in inflation data and cooling labor market conditions, the Fed remains wary of acting too soon. The upcoming U.S. elections also add a layer of political complexity to the Fed's decisions, as policymakers navigate economic objectives alongside political considerations.
Implications for financial markets and institutions
Faibishenko noted the mixed reactions from financial institutions and markets. The rate cut, although modest, was largely priced in by the markets. The bond markets have responded to the ECB’s move with a reduction in yields, while the equity markets have been mixed, reflecting uncertainty around the effectiveness of these measures. However, the broader impact on lending activity remains to be seen, with lending to non-financial corporates, households, and the public sector contracting since 2023.
She highlighted that the 12-month Euribor, a key benchmark for borrowing costs, has fluctuated between 3.4% and 3.9% in recent months. This volatility reflects market expectations around potential ECB rate cuts. With the recent cut now realized, markets have shown some stability, but the true test will be in the coming months as further economic data becomes available.
Households and businesses: What to expect
Faibishenko pointed out that lending to households and businesses has been subdued for several years, even before the recent rate hikes. The pandemic period saw a spike in state-guaranteed loans, but outside of that, demand for credit has been weak. This trend is expected to continue despite the recent rate cut, as economic uncertainty dampens the appetite for new borrowing.
A crucial factor in Spain is the prevalence of fixed-rate mortgages, which account for about 75% of new mortgages in recent years. This means that many households will not see an immediate benefit from the rate cut. Instead, any impact on household finances will unfold gradually as fixed-rate agreements come up for renewal and are potentially repriced at lower rates. Relatedly, the higher prevalence of fixed-rate mortgages will also slow the potential negative impact of rate cuts on banks’ profitability.
It is even harder to predict how the latest monetary decisions will affect financial savings. More time will have to elapse – and we may well need to see more rate cuts – before we can observe this reaction.
The response from the business community is similarly cautious, as companies weigh the benefits of lower borrowing costs against the uncertain economic environment.
Broader Economic Context
The conversation also touched on other critical elements of the ECB's monetary policy, such as liquidity provisions through asset purchase programs.
Faibishenko emphasized that while the ECB's asset purchase programs provide significant liquidity to the markets, they cannot be a permanent crutch. That said, the downsizing of these programs, necessary for long-term financial stability, could introduce new volatility, particularly if not managed carefully. Recent political developments, such as the European elections and unrest in France, have already impacted sovereign risk premiums, highlighting the delicate balance the ECB must strike.
Looking Ahead
As the ECB navigates these challenges, its future actions will be closely watched. Analysts predict a cautious approach with potential further rate cuts in the second half of 2024, depending on economic and geopolitical developments. The ECB's ability to balance growth and control inflation will be pivotal, especially given the differing monetary policies of major economies like the U.S.
Faibishenko emphasized the importance of strong communication strategies and vigilance over financial innovations to mitigate market volatility and boost economic stability. She noted that the ECB's approach must be agile and transparent, ensuring that markets remain informed and confident in the central bank's strategies.
One area to watch is the impact of divergent monetary policies on exchange rates. The ECB's more flexible stance, combined with the Fed's cautious approach, has led to a stronger dollar against the euro. This currency dynamic can affect trade balances and capital flows, influencing economic conditions in both regions.
Conclusion
The recent episode of "Future is Blue" provided valuable insights into the ECB's monetary policy changes and their implications. As the global economic environment continues to evolve, the ECB's decisions will play a crucial role in shaping the financial future of Europe and beyond.
You can listen to the podcast here.
Carlos Carnicero Urabayen