Weekly Update - Euro area: persistently high lending rates will encourage the ECB to go further

The European Central Bank (ECB) has been easing its monetary policy for a year now, with the key rate falling from 4% to 2% in 12 months. While this decline is massive, it has only been very partially transmitted to longer-term interest rates, both on the bond market and on bank loan rates. This low transmission moderates the impacts of monetary easing. The ECB will thus be encouraged to strengthen this easing by the end of the year, in a context of sharp decline in inflation and moderate growth.
 
The ECB is once again lowering rates and adopting a wait-andsee approach. At the June 5 meeting, the central bank's key rate was lowered by 25 basis points to 2.00%. In parallel with this new reduction, the ECB has updated its forecasts and revised its inflation forecast significantly downwards due to the decrease in the price of oil and the appreciation of the euro (inflation is now forecast at 2% for 2025, 1.6% for 2026 and 2% for 2027). However, it maintains its forecasts for core inflation (at 2.4% in 2025, 1.9% for 2026 and 2027) and growth (0.9%, 1.1% and 1.3%) almost unchanged and stresses that the central bank is now approaching the end of its rate cut cycle. The ECB has indeed started to cut rates a year ago and considers its current policy to be "well positioned", which suggests that - without a new shock - it could now keep its policy unchanged.
 
Low transmission at longer-term rates. Since the ECB began its short-term rate cutting cycle, yields on the sovereign bond markets have remained almost stable: German and French 10-year rates have been hovering around 2.5% and 3.2% respectively for more than a year. Several factors explain this stability. First, nominal growth remains higher than before COVID, with inflation close to the central bank's 2% target, which justifies a persistently higher level of equilibrium interest rates. Secondly, the sovereign bond market appears to be under pressure, with on the one hand an increase in supply, in a context of rising public debt (including in prospect in Germany with the planned support plan), and part of the demand decreasing, with central banks continuing their balance sheet reduction programs (Quantitative Tightening operations). These tensions go beyond the eurozone markets alone, with rates remaining high in the United States and rising in Japan. What stands out in the eurozone is that long-term sovereign rates remain high while the Central Bank has already cut rates significantly
 
This is an incentive for the ECB to continue the easing. This maintenance of long-term reference rates at a high level moderates the easing of bank lending rates. For example, new mortgage rates have fallen since their highs at the end of 2023 (see chart) but are still significantly higher than before Covid. The recovery in bank lending also remains moderate, both on the household and corporate sides, limiting the smooth transmission of the more accommodative nature of monetary policy to economies. This partial transmission of the easing of monetary conditions could encourage the ECB to cut its key interest rate further, especially in a short-term context of weakened growth (before the effective implementation of the support plans) and a fall in inflation due to the fall in oil prices in euros.

Other highlights of the week
 
In the key events of the week, we chose to mention the OECD's downward revision of its growth forecasts for the United States and the decline of the ISM in the manufacturing and services sectors. 
 
The OECD is revising its growth forecasts for the US downwards but maintaining those for the euro area.
In the US, the growth forecast for 2025 is significantly lower than the March estimate, reaching 1.6% compared to 2.2% initially forecast. The OECD explains this decline by the effect of customs duties as well as the uncertainty related to the government's action in general, which is causing a weakening of consumption and a reduction in investment. Inflation is expected to rise sharply to 3.9% in 2025 (compared to 2.8% initially forecast), before falling back in 2026. Regarding the euro zone, the OECD maintains its growth forecasts of 1% in 2025 and 1.2% for 2026. Activity will be supported by the easing of financial conditions, the decline in energy prices and the support of the NextgenEU plan. The inflation estimate also remains unchanged, around 2% for 2025 and 2026.
 
US: ISM declines in the manufacturing and services sectors. The ISM manufacturing index fell to 48.5 in May, below the 50-point threshold that signals a contraction in activity. This is the third consecutive month that the index has been in contraction territory. In detail, the weakness of the index is explained by the new orders subcomponent, which remains in contraction territory at 47.6 and the employment sub-index at 46.8. In the service sector, the situation is also deteriorating. The ISM services fell to 49.9, against the consensus of 52. The new orders index also moved into negative territory at 46.4, probably as a result of the reduction in front-loading effects (expectations of purchases ahead of the tariff increase) linked to customs duties and the high uncertainty about the direction of economic policy.
Employment remains stable in the United States. The labour market remains robust in the United States. The unemployment rate remained at 4.2%, in line with consensus expectations. On the other hand, wage growth was stronger than expected, at 0.4% month-on-month.

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