Europe's central bank cuts interest rates for first time in 5 years

• The European Union just made its first cut to interest rates in five years.
• The European Central Bank lowered its main interest rate from 4% to 3.75%.
• Officials tend to lower interest rates when inflation is under control and they want to lift growth.

The European Union has become the latest global economy to cut its benchmark interest rate.

The European Central Bank (ECB) announced on Thursday that it would lower its main interest rate from 4% to 3.75%, marking its first reduction since 2019. Canada cut its key policy rate from 5% to 4.75% on Wednesday.

Neil Birrell, chief investment officer at Premier Miton Investors, said in a research note to clients:

"In one of the most flagged central bank interest rate decisions for some time, the ECB followed Canada into the rate cutting cycle. However, the path for further cuts is unlikely to be as predictable or smooth."

"Eurozone inflation is proving more resilient than hoped, as it is in the US and UK, which has to influence the ECB, although they will be keen to keep providing stimulus to the economy, it needs it. As has been the case all the way through the cycle, they have a tight rope to walk," he said.

Economies worldwide have raised interest rates significantly over the last two years after inflation surged following the COVID-19 pandemic.

For example, US inflation surged to a 40-year high of over 9% in the summer of 2022. The US central bank responded by hiking interest rates from nearly zero in early 2022 to over 5% currently, and has yet to make its first cut.

Central banks raise interest rates to cool inflation, as higher rates make it more attractive to save instead of spend or invest, and deter companies from hiring by raising the interest payments on their debts. The result is usually less overall demand in the economy, which helps to relieve upward pressure on prices.

However, consumers and businesses in Europe, the US, and elsewhere have faced a painful combination of historic inflation and sharp rate increases. They're now paying significantly higher prices for food, fuel, housing, and other essentials, and also higher monthly payments on their cars, mortgages, credit cards, and other debts.

The cost of living crisis has heaped pressure on central banks to cut rates, but stubborn inflation has made doing so a tough decision for the likes of ECB President Christine Lagarde.

Indeed, annualized inflation in the EU ticked up from 2.4% in April to 2.6% in May — above the ECB's 2% target. At the same time, the EU is only expected to increase its gross domestic product (GDP) by 1% this year, fueling calls to stimulate growth by lowering rates.

"Since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly," the ECB said in its press release.

"Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons."

However, the central bank noted that "domestic price pressures remain strong" and "inflation is likely to stay above target well into next year," signaling that markets shouldn't expect a flurry of cuts in the months ahead.