Reflections on the Recent European Central Bank Interest Rate Cut and its Underlying Reasons

Bit World News Report:
On June 6, the European Central Bank (ECB) announced its decision to cut the three major interest rates by 25 basis points for the first time in five years.
Before the Federal Reserve, the ECB lowered its main refinancing rate from 4.50% to 4.25%. Traditionally, the Federal Reserve will be the first to lower interest rates.
At the same time, the marginal lending facility rate and the deposit facility rate were reduced to 4.50% and 3.75% respectively. But why now, and what does it mean for the eurozone?
More context
Just so we don’t forget, central banks around the world have raised interest rates to control the high inflation caused by the pandemic and the energy shockwave caused by Russia’s aggression in Ukraine.
As a result, economies dependent on the euro, as well as rising prices in the United States and the United Kingdom, have eroded purchasing sentiment, leading investors to turn to safe-haven assets such as gold or silver.
Since then, the situation has improved significantly. Although some prices continue to rise, especially in the service sector, overall inflation has decreased, giving the business sector a breather and reigniting investor interest in alternative assets.
Despite making progress in controlling inflation and bringing it closer to the target of 2%, the ECB has not been eager to continue lowering interest rates. This stance is seen by many as “hawkish,” as the central bank remains committed to “maintaining rate constraints when necessary” while pursuing a “data-dependent approach at each meeting.”
Direct impact on the euro
The divergence in monetary policy between the United States and Europe has slightly weakened the euro. If between mid-April and mid-June, the single currency strengthened against the US dollar from 1.062 to 1.070, considering the asynchronous monetary policies between the ECB and the Federal Reserve, the euro against the US dollar may face further depreciation.
Why is the euro weakening?
There are at least three reasons behind the weakness of the single currency. First, as the Ukraine war dragged on for almost two years, energy costs reached record highs, increasing the necessity for European production and exports, especially in the energy sector, which has never been more apparent than now.
For example, unlike the United States, which is both the world’s largest energy producer and consumer, the EU has not caught up in production.
The EU still heavily relies on fossil fuels from Russia, and the loss it bears in high energy prices is much greater compared to the United States. It is well known that the United States has the ability to offset the loss of purchasing power as an energy consumer and the gains as an energy producer.
It may take quite some time for Europe to achieve its green energy goals and break free from its dependence on fossil fuels. This leads to the second reason – a stronger US dollar.
The Federal Reserve has already raised key interest rates three times this year. A significant amount of cash has started flowing into the US economy, benefiting from higher interest rates. Following the old saying “the higher the interest rate, the greater the demand for the currency,” the US dollar has appreciated due to increased demand.
The third reason is more related to the market’s reaction to the current economic environment. As mentioned earlier, during uncertain times, investors tend to shift their focus to what they perceive as safe havens.
Currently, the US dollar is the only global currency, making it the universal medium of exchange for goods and services worldwide. This helps it be seen as a safe haven, attracting investors.
However, caution must be exercised, and investors should continue to monitor the market situation and assess risks based on fundamentals and technical data at hand.
Are there any positive factors for the weak euro?
The weaker euro has both disadvantages and significant advantages. The first and most important advantage is the rise in export costs. European products priced in dollars become more affordable in the United States, which in turn increases demand for EU goods instead of locally produced, similar, and more expensive products.
The tilt towards EU economies and higher export demand will encourage European companies to produce more goods and services. By doing so, they create employment opportunities, hire more labor, and increase the supply chain. Therefore, higher exports have a crucial impact on the domestic economy, allowing it to expand.
However, the positive impact of a weaker single currency is offset by negative aspects.
Negative effects of the weak euro
The flip side of increased exports is the increased cost of imports paid in dollars. This applies not only to final goods but also to dollar-priced raw materials, meaning EU consumers will pay more for imported goods from the United States.
This gradually erodes consumer confidence and damages demand. Therefore, European companies need to be prepared to cope with declining demand that could lead to an economic downturn.
On the other hand, rising import prices may also have a positive effect on eurozone businesses. As American products become more expensive, Europeans may eventually turn to similar European products that offer better value for money. This stabilizes production and employment in the eurozone.
Nevertheless, the Federal Reserve’s delay in cutting interest rates will only widen the gap between key rates in the EU and the United States.
Meanwhile, the main gains for traders and investors come from understanding the market and macroeconomic events, such as monetary policy decisions by the ECB and the Federal Reserve. Keeping up with key economic events and data releases can help them make wiser decisions during turbulent times.
Author: Marios Chailis, CMO Libertex Group
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