In recent weeks the guidance from several ECB Governing Council members had become increasingly clear that the June meeting would see its first rate cut in this cycle. Against this background, not acting was out of the question, despite the uptick in the latest inflation data. Moreover, there was an upward adjustment of the ECB staff inflation forecast. Unsurprisingly, during the post-meeting press conference ECB President Christine Lagarde insisted the decision was only “removing a degree of restriction”, that policy remained restrictive and that further decisions would be data dependent.
The focus of households, companies and financial markets has now shifted to the timing and speed of further reductions in the deposit rate.
To put it differently: what is the ECB reaction function? On many occasions in recent months, Governing Council members have insisted that three factors are key: the strength of monetary transmission, the recent underlying dynamics of inflation and the inflation outlook. But concretely speaking, what can we expect, considering that monetary policy decisions have a forward-looking component given the lags of monetary transmission.
A recent ECB working paper on the ECB’s new area-wide model provides an estimate of an interest rate rule, which, according to the authors tracks well actual policy, suggesting that it captures the ECB’s reaction function adequately. The explanatory variables that go into the policy rule equation are the gap between observed and target inflation, the change in this gap, the output gap, the change in the output gap as well as an assumption about the neutral rate and the inflation target.
Based on the parameters estimated in the working paper and the inflation and growth forecasts in the June ECB Staff Forecasts, one can estimate the expected path for the deposit rate. As shown in the chart, a gradual decline is projected based on further progress in terms of disinflation. By the end of 2026 the deposit rate would converge to 2.0%.
It goes without saying that the inflation projection plays a key role. The blue line in this chart shows an alternative scenario, with inflation stuck at 2.4% until the end of 2025 and dropping to 2.0% in 2026. This makes a huge difference for the deposit rate, which would still be at 3.5% at the end of 2026.
Clearly, these projections should not be considered as a forecast. Policy will remain data-dependent and the Governing Council may decide to ease more swiftly or more slowly than implied by the model. Nevertheless, the projections provide a useful reference point and allow us to analyse the sensitivity of the deposit rate path to different economic assumptions.
