Since late 2021, inflation has been one of the biggest economic storylines across the world. While we’ve covered this topic in depth many times, an inflation cycle works like this:

When an economy heats up, prices tend to go up with it.
If the economy gets too hot, then the rate of price increases (aka inflation) accelerates.
This acceleration leads to more growth, which can quickly spiral out of control.
Central bankers try to prevent runaway inflation by raising deposit interest rates to cool the economy.
With higher interest rates, borrowing money becomes more expensive while saving money gets more attractive.
Eventually, economic activity cools, and inflation returns to normal levels.

Over the past two years, we’ve watched the first part of this cycle play out, with prices increasing quickly and central banks across the world raising rates to keep a lid on it.

Last week could’ve very well signaled a new chapter in the process, at least here in the Eurozone. On Thursday, the European Central Bank (ECB) cut their benchmark deposit rate from 4% to 3.75%.

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Why this cut is a big deal

First, it’s the first cut they’ve made since 2019, when interest rates were already below zero. At that time, the economy looked radically different. Growth was sluggish, and with no real meaningful investment from governments, the ECB had no choice but to create ‘free’ money to stimulate economic activity. Negative interest rates effectively punished people for leaving funds in their savings account (even if most people were happy with the pain). Now, the economy has a new make up where growth has (somewhat) returned to the continent.

Second, the ECB is the first major Western central bank to cut interest rates. Inflation this decade is a global phenomenon with almost no country spared; even Japan saw their economy inflate. When central bankers raise interest rates, they know it will take some time before the effects appear on the economy. This lag can be anywhere between months to even years, and it’s almost impossible to predict when that tide will turn. The ECB’s cut last week could be the start of a new phase in the global economy where interest rates and inflation will slowly go back to more normal levels.

Third, investors and even savers will need to start paying attention. Lowering interest rates makes investing in stocks more attractive as the ‘real’ return becomes bigger than a comparative risk-free investment. Here’s how that works.

If you can earn 6% by investing in the stock market and 4% by leaving your money in the bank, your real return in stocks is 2%. If the central bank cuts rates to 3.75%, then the real return increases to 2.25%. Stock investing did exceptionally well last decade since the risk-free rate of return was effectively zero for nearly 10 years.

Savers and investors in money market funds will also see their deposits pay less with this rate cut. Banks set the rate on their savings account based on the benchmark rate from the central bank. When the central bank cuts, they lower the amount depositors receive for investing. Money market funds will see the same impact.

Collectively, we as a society love to procrastinate any meaningful investment decision and instead choose to save until we can figure it out (which we also put off to our future self’s displeasure). Since interest rates went up, we’ve all been rewarded for parking our cash in different bank accounts. As central banks cut interest rates, savers are set to shoot the older version of themselves in the foot as they won’t receive as much for their deposits.

Finally, interest rates impact exchange rates. If the Eurozone cuts its rate but the Federal Reserve keeps theirs high, the dollar will look like a more attractive place to park funds versus in euros. Higher demand for dollars from euro-holders means the euro will weaken, bringing the exchange rate closer to 1:1 (although we have a long way to go before parity).

Is a new phase of the 2020s economy on the horizon?

Together, the economy could very well be changing again, and we’re witnessing the first steps. To be clear, this cut was a modest one, and interest rates in the Eurozone are still far higher than they’ve been since 2008. There’s no guarantee that rates will go lower any time soon. Inflation is still around and Europe’s economy is sort of all over the place. If inflation returns, the ECB could just as quickly raise rates again. It’s also worth remembering that only the ECB has cut rates. The Bank of England and the US Federal Reserve have yet to make similar moves (even if they’re predicted to). Whatever the case, the economy is changing once again and it’s always good to understand what it means for you and your wealth-building needs.

Europe’s elections: what it might mean for the economy

This weekend, voters across the European Union went to the ballot box to vote for their next members of European parliament. While results are still pouring in and it’s far too early to make any concrete predictions on economic policy for the next five years, we can make a couple of quick analyses.

First, despite the rise in euro-skeptic parties on both the hard right and left, the pro-European parties of the mainstream left, center and right still dominate the European Parliament. Any plans to radically upend the European project will have to wait at least another five years when voters go back to the ballot box.

Second, with a pro-European majority, we should expect to see more progress in deepening economic integration across the continent. The previous parliament has already made progress on advancing financial regulations that standardize the rules for money and investments in member states. With the proposed European Capital Markets Union (EMU) high on the last parliament’s agenda, there’s a good chance we’ll see progress in making investing and raising capital more efficient within the EU.

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