The European Central Bank (ECB) has cut its main interest rate for the first time in almost five years becoming the second major central bank to do so, after the Bank of Canada earlier last week.

Deposit rates have been cut to 3.75 per cent from a record high of four per cent, putting the ECB ahead of the Federal Reserve and the Bank of England, which have yet to cut interest rates. The ECB attributes the cut to a sustained fall in inflation, as financial markets eagerly anticipated the first eurozone cut since September 2019, which will see its main refinancing operations rate, falling from 4.5 to 4.25 per cent.

However, the ECB expects inflation to be marginally higher this year and in 2025 than it was forecasting in March. It said inflation would average 2.5 per cent in 2024 and 2.2 per cent in 2025, up from its previous forecast of 2.3 per cent and two per cent, respectively.

City analysts had forecast the reduction in borrowing costs at the ECB’s June meeting after signals that the central bank was ready to offer more support to eurozone economies after a period of economic stagnation following the Russian invasion of Ukraine.

ECB explains reason for rate cut

In a statement announcing the rate cut the ECB said “Keeping interest rates high for nine months has helped push down inflation. It is now appropriate to moderate the degree of monetary policy restriction.”

ECB president Christine Lagarde expressed the central bank’s confidence that its forecasts were robust and, if inflation continued its longer-term downward trajectory, interest rates would continue to fall. Lagarde explained that pay settlements were moderating and companies were absorbing some of the increase in labour costs rather than passing them on to consumers, dampening inflationary pressures.

However, she added that there were still risks to the outlook for inflation arguing, “Despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year.”

Reacting to the news, Dean Turner, chief eurozone economist at UBS Global Wealth Management said the outlook for inflation, as indicated by the ECB’s latest projections, point to further interest rate reductions later this year.

In conclusion, he added, “Of course, the timing of the next move from the ECB is uncertain, as this will be dependent upon incoming data. But with the disinflationary process firmly underway, the ECB, along with other central banks, should feel confident enough to ease policy, most likely at a pace of one cut per quarter.”