Economists have a knack for elevating seemingly simple assumptions into so-called science—even though economics isn’t really a science at all. Nevertheless, endless books are written about a single abstract interest rate number.
Now that inflation has once again fallen below 2 percent, it is almost 100 percent certain that the ECB will cut rates further. Based on market data, the average expectation is for more than two cuts this year (2.2 at the time of writing, based on overnight index swaps). If the markets are right, rates will fall below 2 percent before the end of the year.
Markets are now aiming for an ECB rate of 1.75 percent by the end of 2025. That includes the expectation that the tariff war will at least contribute some inflationary pressure. Meanwhile, economic growth in the Eurozone currently stands at 1.2 percent, which I would argue is slightly above the region’s average potential growth. A policy rate of 2 percent or even lower is simply low in that context.
Eurozone – Inflation
R-Star
Such a rate level is also below the estimated R*, the central bank interest rate at which the economy is in equilibrium, growing at its potential pace with inflation stable around the ECB’s target.
While most estimates of R* immediately jump to a nominal figure, a real benchmark makes more sense. Given that we can still expect a small amount of real GDP growth, the real R* usually falls somewhere between 0 percent and 1 percent, leaning slightly toward the latter.
Add the ECB’s inflation target to that, and for simplicity’s sake, you arrive at an R* of 2.5 percent. If, like me, you factor in a higher inflation rate—needed to prevent France from sparking a eurozone debt crisis like the one between 2010 and 2012—then, by economist logic, you’d be looking at an R* closer to 3 percent.
From that traditional viewpoint—and considering the ECB’s complete misjudgment of inflation—an interest rate of 1.75 percent should raise a few eyebrows. Now, it may be that the ECB and the markets are quietly assuming a growth rate even lower than the roughly 1 percent we are currently seeing. Given demographic trends, a lower potential growth rate wouldn’t be unreasonable, though you’ll never hear an ECB official or economist say that. To me, however, it’s an obvious reason why the real R* might actually lie below zero.
Puzzle
So it’s a bit of a puzzle: with inflation around 2 percent and growth at 1 percent, we’re already steering toward rates below 2 percent. Especially since Powell, across the ocean, has made it crystal clear that the Fed won’t act again until the impact of the import tariffs becomes clearer. Now, if Trump manages to sidestep his own judges, the United States will face more inflationary pressure. Inflation there is also around 2 percent, and growth was negative in the first quarter—though a strong rebound is expected in the current quarter.
Still, the discrepancy between the ECB and the Fed remains striking—at least until you consider the other, implicit objective of central banks. There it is again: debt sustainability. Europe needs to go all-in to make up for years of neglect in defense spending. That’s not going to help the already out-of-control budgets. In the UK, the government wants to raise defense spending to 3 percent of GDP, but has absolutely no idea how to fund it.
So, in the spirit of “every little bit helps,” it’s rather convenient if the ECB pushes rates lower in advance. Just like the inflation risks—those have to take a backseat to the greater good. As long as the ECB doesn’t come out with a wildly optimistic inflation forecast or an overtly negative outlook on the Eurozone economy, this seems by far the most plausible explanation. One that economists could well include in their endless R* debates.
Jeroen Blokland analyzes striking, current charts on financial markets and macroeconomics. He is also the manager of the Blokland Smart Multi-Asset Fund, which invests in stocks, gold, and bitcoin.