ECB to hold rates and take baby steps towards first cut

By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) - The European Central Bank is set to keep interest rates at record highs on Thursday and take baby steps towards cutting them in the coming months as inflation continues to fall.

Having reacted too slowly to a sudden surge in prices two years ago, the central bank for the 20 countries that share the euro is now reluctant to declare victory over the most brutal bout of inflation in decades.

It is universally expected to keep its policy rate at a record 4.0%, and ECB policymakers are likely to repeat that they need more evidence inflation is under control and that ongoing wage increases will not give it another leg up.

But the ECB's new economic projections are likely to point to lower economic growth and inflation this year, which may require the central bank and its president Christine Lagarde to tweak their message slightly.

"We expect a neutral policy stance and balanced communication, acknowledging the continued progress on inflation but avoiding a premature declaration of victory," said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.

Sources have been telling Reuters for months that the ECB is unlikely to reduce borrowing costs before its June 6 meeting as crucial data about wages will only become available in May.

This gives the ECB another meeting - on April 11 - to explicitly open the door to what ECB Chief Economist Philip Lane has said is likely be the first in a series of rate cuts.

Investors have pencilled in three or probably four reductions by the end of the year, which would take the rate the ECB pays on bank deposits to 3.25% or 3.0%.

The ECB will announce its rate decision at 1315 GMT and Lagarde will hold a press conference at 1345 GMT.

INFLATION

Inflation has been coming down for nearly 18 months and it was 2.6% in February, slightly above the ECB's 2% target.

This was partly the result of a steep fall in fuel costs, which had been boosted by Russia's invasion of Ukraine, but also reflected the ECB's steepest ever increase in borrowing costs, which has brought lending to a standstill.

But inflation excluding volatile food and fuel prices was still at 3.1%, as a rebound in real wages buttressed the price of services.

"Disinflation is going much quicker than we expected on the headline level but we can't be certain yet about core inflation because wage developments remain unclear," ECB policymaker Peter Kazimir told Reuters in a recent interview.

His German colleague - and fellow policy hawk - Joachim Nagel also said the ECB should resist the temptation to make an early rate cut, and wait for wages data.

The ECB's quarterly macroeconomic projections, due to be published on Thursday, are nevertheless set to confirm the trend.

The inflation expectation for this year is likely to be cut from December's 2.7% projection on account of much lower gas prices. Economists polled by Reuters see 2024 inflation at 2.3%.

That means the ECB may hit its inflation goal later this year, rather than in 2025 as it has been expecting.

GDP growth for 2024 was also likely to be cut, reflecting a weaker than expected recovery, particularly in Germany.

Flagging growth and inflation has led several members of the ECB's policy-making Governing Council, including Spanish central bank chief Pablo Hernandez de Cos, to start talking about an upcoming a rate cut. Greece's Yannis Stournaras has pointed to June as a likely date.

"This will make it very difficult for the European Central Bank President to kick the ball into the long grass," Gilles Moec, chief economist at French insurer Axa, said.

"Yet, the Governing Council is at this stage probably too divided for her to go beyond an admission that the internal debate has started."

Lagarde is also likely to face - and dodge - questions about the ECB's ongoing review of its framework for steering market rates in an era of higher inflation and on the central bank's mounting losses.

Sources have told Reuters that policymakers have agreed on a new framework - which would see the ECB keep a "floor" under market interest rates - but no announcement is expected until later this month, at the earliest.

(Editing by Catherine Evans)