This week, the European Central Bank is poised to make its third interest rate reduction of the year.

• The European Central Bank is set to make its third interest rate reduction of the year during its meeting on Thursday, as policymakers indicate that inflation risks are decreasing at a faster pace than anticipated.
• On Monday morning, markets predicted a 25 basis point reduction in October and a 3% cut at the final meeting of the year in December.
• This week, the ECB is not expected to change its guidance, and President Lagarde is not anticipated to adjust expectations for quicker rate cuts.

The European Central Bank is set to make its third interest rate reduction of the year during its meeting on Thursday, as policymakers indicate that inflation risks are decreasing at a faster pace than anticipated.

In September, the headline price rise in the euro area decreased to 1.8%, below the central bank's target of 2%. Additionally, core inflation, which excludes energy, food, alcohol, and tobacco, reached a two-and-a-half year low of 2.7%.

Despite the ECB cutting interest rates by 25 basis points in June and September, and lowering its key rate from 4% to 3.5%, the figures have not significantly increased.

Money markets had predicted a 25-basis-point reduction during the October meeting and a follow-up cut to 3% at the final gathering of the year in December, as of Monday morning.

Since the ECB's Sept. 12 meeting, there have been rising expectations for faster monetary easing due to a series of dovish comments from officials and cooler-than-expected inflation prints from euro area states, including Germany. Bank of France Governor Francois Villeroy de Galhau last week stated that an October rate cut is "very likely" and that such a step "won't be the last."

According to Villeroy, who spoke on France Info, there is hope for victory against inflation, but some volatility and increases in the headline rate may occur.

Christine Lagarde, the ECB President, informed European Union parliamentarians last month that recent developments have boosted her confidence that inflation will return to the target in a timely manner. This will be taken into account in October. Analysts at Citi characterized this signal as a "pivot" from Lagarde's previous message on September 12, which suggested a "gradual approach" to rate cuts was more suitable, given the risks to the inflation outlook.

Joachim Nagel, head of Germany's Bundesbank, stated earlier this month that the inflation trend was "good news" and expressed his willingness to discuss another cut.

Weak growth

The continued sluggishness in euro area economic activity and the tone set by the U.S. Federal Reserve's Sept. 18 decision to press ahead with a 50-basis-point rate reduction have raised expectations of back-to-back cuts.

The immediate impact of softer activity data and faster disinflation on ECB communication and markets was noted by Barclays strategists in a Sunday note.

According to consultancy Capital Economics, composite purchasing managers' index figures for the third quarter indicate stagnation, following tepid 0.3% growth in the second quarter.

A flash reading for the third quarter will be released on Oct. 30.

The tight monetary policy is hindering growth, along with structural problems such as the decline in German industrial competitiveness, according to Jack Allen-Reynolds, Capital Economics' deputy chief euro zone economist, who predicted that the ECB will make rate cuts this week and at every subsequent meeting until the deposit rate reaches 2.5%.

He stated that the outlook is also due to a cooling labor market and slower wage growth helping bring down services inflation in the months ahead.

The ECB reduced its annual euro zone growth forecast to 0.8% from 0.9% due to weaker domestic demand.

Adjustment in language

Bank of America Global Research economists predicted in a Sunday note that the ECB would reduce interest rates this week without significantly altering their guidance.

They stated that this marks the beginning of the accelerated path towards achieving 2% rates by June 2025 and ultimately reaching 1.5% by the end of 2025.

"Despite this, the ECB is unlikely to reveal anything of the sort. The meeting-by-meeting approach and data dependence are likely to remain firmly in place, with perhaps just verbal references to rising confidence that inflation is on track to return to target."

Holger Schmieding, Chief Economist at Berenberg, believes that Lagarde will not adjust market expectations for a December rate cut during her press conference on Thursday, thereby finalizing pricing. Schmieding predicts that the ECB may need to revise its growth forecast for 2024 even more when it releases new staff projections in December.

He warned that the central bank may overreact and ease monetary policy too quickly, putting it at risk.

Inflation should not be a significant concern next year, according to him. However, he believes that this will not be the case in 2026 and 2027.

If the euro area's growth rate returns to normal in spring of next year, as the ECB expects, wage inflation will rebound, and more robust demand will allow companies to pass higher costs on to consumers, it was argued.

According to Schmieding, if the ECB lowers the deposit rate to less than 3% in 2025, it will likely raise it back to 3% in late 2026 or early 2027.