As the European Central Bank (ECB) navigates the choppy waters of economic uncertainty, policymakers within the institution are increasingly at odds over the appropriate course of action. This internal rift, which centers on the outlook for growth and inflation, has the potential to influence the trajectory of interest rate cuts for months to come.

The ECB, which took the step of cutting interest rates in June, is almost certain to ease them again in September, as signs of slowing price growth continue to emerge. However, the decisions that follow may prove more contentious, as the euro zone economy faces a precarious and uncertain future. Conversations with close to a dozen sources suggest that the bank’s leadership is divided on how to proceed, with some fearing an imminent recession, while others remain focused on the persistent threat of inflation.

At the heart of this debate lies the question of how economic weakness and a potential recession will impact inflation, the bank’s primary focus. The ECB’s goal is to bring inflation down to 2% by the end of 2025, but differing views among policymakers on the best way to achieve this could lead to significant policy shifts in the coming months.

While much of this discussion remains behind closed doors, sources with direct knowledge of the internal deliberations have revealed that opinions are diverging. An ECB spokesperson declined to comment on these internal debates, but the divide is becoming increasingly clear.

The Case for Aggressive Rate Cuts: A Growing Minority

Among the ECB’s policymakers, a minority known as the “doves” argue that the euro zone economy is weaker than previously thought. These officials believe that the risks of a recession are rising and that firms that have hoarded labor in recent months are now beginning to cut vacancies. As the job market softens, they argue, employment will decline, leading to a reduction in disposable income and a subsequent drop in consumption. This self-reinforcing downturn, they warn, could weaken price pressures more quickly than currently anticipated.

One source, who requested anonymity, emphasized the risk of inflation falling below the ECB’s target. “This would weaken price pressures quicker than we now forecast, so I think the risk of returning to below-target inflation is real,” the source said. This perspective suggests that the central bank may be behind the curve in cutting interest rates and supporting the economy, lending support to the argument for more aggressive rate cuts in the near term.

Hawks Argue for a Cautious Approach

On the other side of the debate are the “hawks,” a group of policymakers who have dominated the ECB’s decision-making process since the rapid rate hikes began in 2022. These officials argue that the euro zone economy is more resilient than the weak survey results suggest. They point to several factors that, in their view, demonstrate the economy’s strength: robust consumption, a strong tourism season, and a rebound in construction.

Moreover, they argue that wage growth remains far above the levels consistent with a 2% inflation target, which means that real incomes are recovering quickly and should continue to provide a cushion for the economy. While they acknowledge that the industrial sector is in a deep downturn, potentially dragging Germany into a recession, they see this as a structural issue that will take years to resolve and is largely beyond the reach of monetary policy.

These hawks advocate for a more measured approach to rate cuts, perhaps one per quarter, until there is greater certainty that inflation is on track to return to 2%. They are also likely to resist any policy easing that would push the timeline for achieving the inflation target into 2026, fearing that such a delay could damage the ECB’s credibility.

One prominent hawk, ECB board member Isabel Schnabel, recently reiterated her belief that inflation should remain the central focus of monetary policy. “Monetary policy should remain focused on bringing inflation back to our target in a timely manner,” she said in a speech on Friday. “While risks to growth have increased, a soft landing still looks more likely than a recession.”

September Decision Unlikely to be Affected, but Future Decisions Hang in the Balance

Despite these divergent views, the upcoming September policy decision is unlikely to be affected by this internal rift. There is already broad consensus among ECB policymakers to cut rates again in response to the continued slowdown in price growth. However, the outcome of this debate could have a significant impact on how ECB President Christine Lagarde communicates the decision and on market expectations for the October meeting.

The ECB is expected to maintain its “meeting by meeting” approach to setting policy, which means there will be no firm commitment regarding October’s decision. However, doves within the bank are pushing for Lagarde to highlight the growing risks to economic growth and to signal that back-to-back rate cuts are not off the table.

Hawks, on the other hand, fear that such a message would heighten market expectations too much, potentially putting the ECB in a difficult position. Investors already see a 40% to 50% chance of an October rate cut, and a more dovish message from Lagarde could only strengthen those expectations.

“I think quarterly cuts serve us well and the data just don’t support picking up this pace,” said a third source, reflecting the cautious stance of the hawks.

Economic Outlook Remains Mixed

The debate within the ECB reflects a broader uncertainty about the economic outlook for the euro zone. Economists are also divided in their assessments, with some forecasting a more severe downturn, while others see signs of continued, if modest, growth.

“Even if the U.S. is to avoid recession, Europe might not,” said Thierry Wizman, a strategist at Macquarie. Wizman pointed to weak Chinese demand for European goods and the potential impact of rising political instability in France and Germany as factors that could weigh on consumer sentiment and exacerbate the downturn.

ABN Amro, on the other hand, expects continued growth, albeit at a sluggish pace. “The euro zone economic recovery is struggling to gain momentum,” the bank said in a recent report. “High savings rates suggest consumers are less willing to spend real income gains, especially in France, the Netherlands, and Germany.”

As the ECB grapples with these conflicting signals, the internal debate over the appropriate course of action is likely to intensify. With the euro zone economy teetering on the edge of recession and inflationary pressures still looming, the decisions made in the coming months could have far-reaching implications for the region’s economic future.

(Adapted from USNews.com)