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ECB drops interest rates to 3.75%

The European Central Bank (ECB) cut interest rates by 0.25% to 3.75% - the first decrease in five years.

The rate cut affects three key ECB interest rates based on an inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission, the bank's Governing Council said overnight, adding that "it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady".

From June 12, interest rates on refinancing operations, marginal lending facility, and deposit facility will be decreased to 4.25%, 4.50%, and 3.75% respectively.

This is off the back of inflation in the region falling by 2.5 percentage points and the inflation outlook improving since the bank's September 2023 meeting.

"Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons. Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down," the Governing Council said.

The ECB warned, however, domestic price pressures remain stubborn. Wage growth also remains elevated. The bank predicts inflation will likely stay above target well into next year.

It now forecasts headline inflation averaging 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026.

The ECB said it is determined to ensure that inflation returns to its 2% medium-term target in a timely manner.

In mid-May, ECB vice president Luis de Guindos said geopolitical risks continue to cloud the outlook for financial stability.

"While financial stability conditions have improved in line with reduced recession risks and lower inflation, it remains crucial that we build further on the resilience of the financial system in the light of global economic and geopolitical uncertainty," he said.

Commenting on the rate cut, Principal Asset Management chief global strategist Seema Shah said the justification for starting policy rate cuts is evident.

"The Euro area's inflation backdrop has improved immensely over the past year, with inflation in late 2023 falling at a faster pace than it had risen and inflation expectations remaining firmly anchored," Shah said.

"However, the rationale for further rate cuts beyond June has become increasingly unclear recently. Euro area disinflation progress has started to stall with the latest inflation print surprising to the upside, while the ECB's indicator of negotiated wages rose in Q1, defying the central bank's expectations for an easing."

Further, with evidence of solid employment growth and a cyclical economic upturn have reduced the market's confidence, Shah sees inflation to trend lower over the coming months.

Read more: ECBEuropean Central BankGoverning CouncilLuis de GuindosPrincipal Asset ManagementSeema Shah