Europe's return to zero rates?

LONDON, Oct 27 (Reuters): If markets are correct, inflation-adjusted European Central Bank interest rates could be back negative by the middle of next year - and a return to zero policy rates cannot now be dismissed.

The sands under ECB easing expectations appear to have shifted again after last week's third rate cut of the year and with headline inflation at least now back well below the targeted 2 per cent.

The International Monetary Fund once again this week cut next year's euro zone growth forecast to 1.2 per cent, now a half-point less than it saw in January and below the ECB's own 1.3 per cent outlook as Germany's struggles drag on the wider bloc's fortunes.

And now ECB officials are debating what to do if inflation persistently undershoots its 2 per cent target.

Even though ECB chief Christine Lagarde and others publicly urge caution ahead, the discussion about whether the central bank might need to start stimulating the economy going forward appears to be under way internally.

"I wouldn't take for granted, given the pace of the disinflation and the weakness of the real economy, that we have to stop at the neutral rate, and we cannot exclude that we will go below neutral," Italian central banker Fabio Panetta told an IMF event this week.

Money markets have already reacted by dropping their estimate of ECB policy rates for the end of next year by half a percentage point to 1.7 per cent over recent weeks - remarkably as US Federal Reserve equivalents jumped about half a point over the same period.

The 4 per cent recoil in the euro/dollar exchange rate this month comes as no surprise in that environment.

But if implied market rates of 1.75 per cent or less from July 2025 onwards prove accurate - 150 basis points below current settings - then the ECB would have to cut a quarter-point at every meeting between now and then.

Either that or it steps up the size of the cuts - and hence renewed talk of a 50bp move at one of its coming gatherings.

And strikingly, if ECB forecasts of a return of inflation to 2 per cent next year play out, the "real" policy rate in that whole scenario would end up being negative again - back where it languished for most of the past decade and after just 20 months in positive territory.

Here the picture gets murkier - though no less profound given post-pandemic hand-wringing about "higher for longer" interest rates.

If headline inflation were to remain stuck around current levels of 1.7 per cent through next year, which is what one-year inflation swaps seem to imply, then the market rate horizon then only plots "real" rates at zero by July.

But given that zero is where most ECB estimates place a "natural rate" of interest - the theoretical rate that neither bears down nor spurs economic activity - the discussion about stimulating the economy suggests actual policy rates may need to go lower than even markets now price.

Despite all the ifs and buts related to that, sub-neutral real rates may then require ECB policy rate settings as low as 1-1.5 per cent.

Yet, as so often with theoretical head-scratching around neutral rates, there are no concrete estimates - only second-guessing of what the ECB itself might think.

ECB researchers, opens new tab have pointed out this year that some neutral rate models have not been fully updated since the pandemic shock upended many assumptions about labour markets, supply disruptions, economic slack and activist fiscal policy.