FRANKFURT — The European Central Bank left its key discount rate unchanged at a record high of 4 percent on Thursday and signaled it has no plans to cut interest rates any time soon.  

The decision had been widely expected, as inflation has started to slow and economic growth has gone into reverse as a result of previous rate increases, which are now squeezing corporate and household borrowers hard.

The bank now expects a sustainable return to the 2 percent inflation target from 2025 onwards, implying that it won’t need to add to what has been its most aggressive policy tightening in 25 years.

However, it warned against reading too much into a sharp drop in headline inflation in recent months, saying: “Underlying inflation has eased further. But domestic price pressures remain elevated, primarily owing to strong growth in unit labor costs.”

And at her press conference, ECB President Christine Lagarde stressed that the ECB was not about to ‘pivot’. 

“We did not discuss rate cuts at all. No debates, no discussion,” she said. “We don’t believe that it’s time to lower our guard. We think there is still work to be done.”

Lagarde has indicated that the ECB will not cut interest rates before mid-2024, the surprising dovishness of Fed chair Jerome Powell on Wednesday, coupled with a much faster-than-expected decline in headline inflation in the eurozone, has led investors to bet on the ECB cutting as soon as March.

Powell’s comments had already led the euro to rise by more than 1 cent against the dollar late on Wednesday. Lagarde’s comments pushed it up another half a cent to around $1.0960. Bond markets, for their part, also responded positively, with the spreads between German yields and those in Greece and Italy narrowing sharply (although here, too, they reacted more to Powell than to Lagarde).

As such, the bank’s core message was little changed from September.

“The Governing Council considers that the key ECB interest rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution” to restoring price stability, it said, adding that it will set policy “at sufficiently restrictive levels for as long as necessary.”

However, as a signal that “sufficiently long” may not be as long as previously thought, it dropped the opening line to statement that said inflation is “still expected to remain too high for too long.”

New staff forecasts show inflation is expected to fall gradually over the course of next year, before approaching its medium-term target of 2 percent in 2025 and subsequently staying there.

Inflation is seen averaging 2.7 percent next year, 2.1 percent in 2025 and 1.9 percent in 2026. This represents a downward trend revision to the previous forecast three months ago, especially for next year. Underlying inflation, excluding the volatile components of energy and food, is expected to come down more slowly to 2.3 percent in 2025 and 2.1 percent in 2026.

The ECB also trimmed its growth forecasts and now expects the region’s economy to expand by 0.6 percent in 2023, by 0.8 percent in 2024, and by 1.5 percent in both 2025 and 2026.

PEPP wind-down to start earlier

Arguably more interesting was the Governing Council’s decision to move up the date at which it will start winding down its so-called Pandemic Emergency portfolio, or PEPP.

The ECB said it will allow the €1.67 trillion portfolio to roll off by an average of €7.5 billion a month through the second half of this year and will end all reinvestment of maturing bonds at the end of the year. Previously, the ECB had said it would continue reinvesting principal repayments in the PEPP portfolio until at least the end of 2024.

“Getting the PEPP announcement out of the way now reduces the hurdle to earlier rate cuts in 2024,” said Mark Wall, chief European economist at Deutsche Bank, in emailed comments. “While the PEPP exit makes it appear like the ECB is not shadowing the Fed’s dovish pivot, it may have subtly opened the door.”

Lagarde, however, downplayed such talk, saying that “rates are the primary tool and we’re going to use that independently of what happens with PEPP.”

She styled the PEPP decision as “really balance sheet normalization,” noting that the currently supportive conditions in bond markets made now “a good moment to do that.”

“It will continue to operate on the back-burner, if you will, without being significant,” she said, echoing similar lines from the Federal Reserve and Bank of England.

On X, Pictet Wealth Management’s Frederik Ducrozet called the PEPP decision “a drop in the QE ocean”.