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Central Banks’ Race Shakes Currency Exchange Rates

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Photo: The ECB reserves the right to change preferences quickly: Christine Lagarde makes no guarantees about interest rate steps, leaving it to guesswork over coffee grounds and supermarket price tags. Source: Getty Images
Photo: The ECB reserves the right to change preferences quickly: Christine Lagarde makes no guarantees about interest rate steps, leaving it to guesswork over coffee grounds and supermarket price tags. Source: Getty Images

As The Gaze predicted at the beginning of August, on 12 September the European Central Bank (ECB) announced a reduction in key interest rates. Now the markets are waiting for the Federal Reserve’s decision, expected on 17-18 September. So far, it is only clear that the euro has strengthened slightly, while European stocks and cryptocurrencies have also risen modestly. The slowing of inflation in August paved the way for the ECB to cut rates. However, ECB President Christine Lagarde made no promises regarding further rate cuts in October.

 

In fact, the decision to lower the key interest rates, made by the ECB’s Governing Council on 12 September, will be implemented on 18 September. The so-called deposit rate has been reduced from 3.75% per annum to 3.5% per annum. This rate is the main tool through which the ECB's Governing Council manages monetary policy.


Additionally, as announced on 13 March 2024, the spread between the interest rate on the main refinancing operations and the deposit facility rate was set at 15 basis points, and the spread between the marginal lending facility rate and the main refinancing rate will remain unchanged at 25 basis points. Accordingly, the interest rates on the main refinancing operations and the marginal lending facility will be reduced from 18 September to 3.65% and 3.90%, respectively.


What has this led to, and what should we expect next? But first, let's understand why the ECB made this decision.

 

Prices Finally Slowed Down

 

According to preliminary estimates, the rate of consumer price growth in the eurozone has slowed down. Inflation stood at 2.2% in August, marking the slowest increase since July 2021. Annual inflation in the eurozone was 2.6% in July, 2.5% in June, and 2.6% in May. This follows the 5.5% figure at the end of 2023. In the European Union, inflation in July was 2.8%, compared to 2.6% in June and 2.7% in May.


What caused the slowdown? In its report, Eurostat stated that "the slowdown occurred due to a sharp drop in energy prices, as base effects started to take hold in August." Indeed, we have observed a gradual decline in oil prices since spring 2024.


The challenge is that although governments and the ECB have collectively managed to halve inflation over the past 12 months, it still remains above the desired 2% target that the ECB aims to achieve.


To curb inflation, the ECB began raising key rates two years ago, and now it has the opportunity to gradually reduce them. Moreover, the ECB must lower rates to accelerate economic recovery, as the current situation is far from satisfactory.


In the second quarter of 2024, seasonally adjusted GDP grew by 0.2% in both the eurozone and the EU as a whole compared to the previous quarter, according to estimates published by Eurostat, the EU’s statistical office. This is less encouraging considering that in the first quarter of 2024, the figure grew by 0.3% in both zones. This suggests a slowdown in recovery rates, with these rates remaining at noticeably low levels.


This situation was already clear earlier. Therefore, the ECB sought opportunities to begin reducing rates at the first possible moment, as rate cuts are a powerful stimulus for accelerating economic growth. This is why, as early as March this year, Christine Lagarde announced her intentions to start reducing key rates, and the first reduction occurred in June. At that time, the ECB lowered the deposit rate from 4% to 3.75%.


In July, the ECB paused rate cuts, stating that future actions would depend on inflation rates. July's results were disappointing, with inflation accelerating according to preliminary data. This formed the basis of the July decision to keep rates unchanged.


August’s results were more favourable in terms of inflation, giving the ECB the opportunity to continue reducing rates, with hopes that economic recovery will finally accelerate, leading to wage and employment growth.


Thus, there remains a need for further rate cuts, as in some countries, such as Germany, GDP has even contracted. Going forward, everything will depend on how prices behave in September and October. If they remain moderate, the ECB will continue to lower rates.

 

Consequences of the Rate Cut


The real consequence is a rising of the euro relative to the dollar. From its recent high of $1.1163 on 26 August, the euro started to decline and reached $1.1043 on 11 September, ahead of the ECB’s Governing Council meeting. However, the day after the meeting, on 13 September, the euro-to-dollar exchange rate moved to $1.1088.


After announcing the decision on 12 September, Christine Lagarde warned that there is no clear certainty for October and beyond, emphasising that future decisions will depend on current economic data: "We are going to decide on a meeting-by-meeting basis... I am not giving you any commitments regarding this particular date, and our path is far from determined."


It is important to understand that the ECB’s decisions are not the only factor influencing the euro. Equally significant is the policy of the Federal Reserve. It will hold its next two-day meeting on 17-18 September, with many experts expecting a 25-basis-point rate cut by the Fed, from the current 5.5% to 5.25%. This rate has remained at this level for 13 months. Experts’ forecasts for this cut are supported by the positive economic data released on 12 September.


In fact, these expectations of a Fed rate cut can be seen as a factor that led to the slight strengthening of the euro, even after the ECB announced its rate cut. Analysts also refer to this factor in their comments on the rise in European stocks on 13 September.


The Bank of England is acting slightly ahead of schedule, cutting its rate in August from a 16-year high of 5.25% to 5%. However, at its meeting scheduled for next week, it is likely to hold off on further cuts, according to a Reuters poll.


Another potential influence, as demonstrated by the financial market turbulence at the start of August, could be a rate change by the Bank of Japan. There are signs that the Bank of Japan may raise rates. As a result of comments from Bank of Japan representatives, the yen has shown signs of strengthening.


Thus, the global financial market appears to be engaged in a cautious race to cut rates, with the exception of the Bank of Japan, which is playing a different game. As a result, key currencies—euro, dollar, and pound sterling—will fluctuate relative to each other depending on the expected rate cuts by their respective central banks, while the Bank of Japan continues to cause uncertainty.

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