Weekly Update - Lagarde and Draghi highlight weak productivity as a main concern

While the European Central Bank (ECB) recently decided to cut its rates by 25 basis points (bps) to 3.50%, ECB President Lagarde remained evasive on the longer-term outlook, not wanting to commit to a specific trajectory. She highlighted the persistence of domestic inflation, due in part to weak productivity gains. This echoes the report published by Mr Draghi this week on “The Future of European Competitiveness”. In it, he insists on the need to improve productivity, by proposing significant reforms requiring massive investment programs.

Draghi: act now or wither away. In his report, the former ECB President and former Italian Prime Minister makes an alarming assessment of the growth prospects of the European Union (EU), with weak productivity gains as a common thread. He highlights three major challenges for the EU: its lag in terms of innovation, climate change and its external dependence (energy, military, etc.). This observation is not new and these challenges have been among the EU's main objectives for several years. But Mr Draghi denounces the lack of action to remedy them as well as the lack of resources. He proposes several ways to respond to them. First of all, more cooperation where it can be useful (defense industry in particular). Then, reduce barriers to innovation (and therefore bureaucracy) and European fragmentation by completing the single market (capital markets union and banking union - two projects started more than 10 years ago). Finally, the implementation of numerous investment plans, financed both by a better allocation of private savings and by the creation of a European risk-free asset.

While the diagnosis of the European economy was rather well received, the recommended actions quickly met with objections. But without them, according to Mr Draghi, Europe will not be able to face the challenges presented while preserving its social and democratic model – an existential challenge in short.

The ECB cuts its rates but remains vague on the future. Unsurprisingly, the ECB cut its rates by 25 bp for the second time. This decision was taken unanimously, but Ms Lagarde recalled that future rate cuts would depend on the data, in particular because of the still high level of services inflation (4.2% over one year). However, this persistence is due to two relatively low volatility factors: wage growth and weak productivity gains. While wages have recently shown some signs of moderation, productivity remains depressed. Thus, the persistence of domestic inflation could persist and prevent a new decline as early as the meeting on 17 October.
However, other elements could change the situation. First, the recent drop in the price of oil could allow total inflation to fall below the 2% target. Then, if it intensifies, the weakness of activity, particularly in Germany, could reinforce fears of recession, leaving the ECB with little choice. Considering that it could play the cautious card, we continue to expect up to two additional rate cuts from the ECB by the end of 2024.