The EU has become the second major global economy to lower its lending rate this week, citing progress in addressing inflation. The European Central Bank (ECB) announced a reduction in its main interest rate from a record high of 4% to 3.75%. This follows Canada’s decision on Wednesday to reduce its official lending rate.

The ECB’s move coincides with voters heading to the polls for EU-wide elections over the next four days, with the results expected to reflect dissatisfaction with cost-of-living issues. Christine Lagarde, president of the ECB, stated that the outlook for inflation had improved “markedly,” paving the way for the rate cut. However, she warned that inflation would likely remain above the bank’s 2% target “well into next year,” averaging 2.5% in 2024 and 2.2% in 2025. The ECB would maintain a “sufficiently restrictive” interest rate policy as long as necessary to achieve the 2% target, she said. However, she added, “We are not pre-committing to a particular rate path.”

Lindsay James, an investment strategist at Quilter Investors, noted that while the rate cut was widely anticipated, it would still provide relief to consumers and businesses in Europe. She remarked, “The ECB has stolen a march on the Bank of England and [US] Federal Reserve – who are both potentially still a few months away from cutting – and will breathe life into an economy that desperately needs some form of stimulus.”

Central banks have kept rates high for the past two years to curb rising prices, typically targeting an annual inflation rate of 2%. However, high interest rates can suppress economic growth. Lowering rates is expected to stimulate economic activity by making borrowing cheaper for consumers and businesses.

Meeting in Frankfurt on Thursday, the EU’s rate-setting body decided to cut rates despite a slight increase in inflation in May. Inflation rose to 2.6%, from 2.4% in April in the 27-nation bloc. The ECB’s decision followed Canada’s rate cut on Wednesday, which lowered its headline rate from 5% to 4.75% after inflation there dropped to 2.7%. Sweden and Switzerland have also reduced rates.

Lagarde provided a broader economic outlook for the eurozone, expressing increased confidence in future prospects while acknowledging potential challenges. She highlighted that short-term risks to economic growth are balanced, but medium-term risks remain tilted to the downside, citing geopolitical tensions and the climate crisis as potential issues.

Katherine Neiss, chief European economist at PGIM, expressed confidence that the ECB might further reduce rates in the summer or autumn, potentially bringing eurozone rates to 3.5% or lower by the end of the year. She noted that although growth is recovering from last year’s recession, it remains sluggish. This, combined with slowing inflation and easing wage growth, would justify another rate cut.