Fresh economic data suggests that interest rate cuts are around the corner. In theory, that's great news for European countries dealing with massive debt loads, but in practice, it won't make much of a difference.

The European Union's statistics office reported on Friday that annual inflation in the euro zone fell to 2.2 percent in August. In Germany, annual inflation fell to 2 percent for the first time in three-and-a-half years, while in France, inflation remained a little bit more elevated, at 2.2 percent.

Cooling prices give the European Central Bank room to lower interest rates, making it cheaper for both banks and governments to borrow. The Frankfurt-based ECB had raised its key deposit rate to a record high 4 percent to tackle a surge in inflation in the wake of the pandemic.

Finland's central bank governor, Olli Rehn, told POLITICO on Thursday that recent economic data had "reinforced the case for a rate cut at the next ECB monetary policy meeting in September."

Lower interest rates means that countries that borrow the most — like France, Italy and Greece — will pay less interest on new debt. That’s important because they owe debt valued at the size of their entire economy, or more, and are facing special sanctions from the European Commission to get their debt trajectory under control.

Debt control

But the impact of the cuts will be limited. For one thing, much of the debt that countries owe is long-dated, having been issued before or during the pandemic, when it was still cheap to borrow.

"Rate cuts, as well as rate hikes, impact new issuance on the market, so it takes time to roll over the debt. Thus the accounting effect on public finances of such moves is slow to spot," said Radoslav Radev, head of fixed income at UBS La Maison de Gestion.

According to Eurostat, short-term debt — that is, debt which needs to be repaid within a year — amounted to around 20 percent of the total for Italy, while for France that number was closer to 15 percent at the end of 2023.

Longer-dated debt will only be rolled over and reset at new, higher, rates only slowly, as it matures. Cuts in official rates by the ECB may help keep a lid on those refinancing costs, but only to the extent that the Bank can convince financial markets that inflation is beaten. If it doesn’t, then inflation expectations will rise again, and the price of issuing new bonds will have to rise too, as bond investors demand a higher premium to protect themselves.

In a speech in the Estonian capital of Tallinn on Friday, the ECB’s head of markets, Isabel Schnabel, pointed that the length of the latest shock — inflation has been above target for over three and a half years — will incline people to expect higher inflation in future.

“Memory cues make people recall past inflation experiences more rapidly,” she warned. As such, she pushed back against market expectations that the ECB will cut rates at all three of its remaining meetings this year and stressed that “the pace of policy easing cannot be mechanical.”

Another risk is politics, and the willingness of governments to actually reduce their borrowing. France still doesn’t have a government after President Emmanuel Macron called elections in June, and the new parliament has not yet voiced any support for cutting the budget deficit any faster than the old one did. Whereas France used to be able to borrow for 10 years at only 0.25 percent more than Germany, political risk means it now pays 0.7 percent more.

The situation remains volatile, and “the market doesn’t believe the deficit or the debt will regress in the short term,” said Radev.

There are also signs that the overall economy is cooling. In March, the ECB revised its short term growth outlook downwards and may do so again in two weeks’ time when it updates those projections. Germany's economy actually contracted in the second quarter of the year.

Slower growth means less government revenue that can be used to pay down debt. It also means that one of the key measures tracked by the Commission — debt as a proportion of GDP — improves less quickly. As a number of countries are about to find out, assumptions about future growth will play a big role in how they manage their so-called Excessive Deficit Procedures. In short, there are no silver bullets — not even from the ECB.