ECB happy on hold for now

The Governing Council re-iterated its message that it is comfortable with its current stance, noting that ‘the incoming information is broadly in line with the Governing Council’s previous assessment of the inflation outlook’. Indeed, the June staff projection showed that although inflation would undershoot the inflation goal in the coming months, it would crucially be back to target over the medium term. Although that projection did incorporate another 25bp rate cut later in the year, President Lagarde swiftly skipped over this point when asked in the press conference. She repeated that the ECB judged that it was currently ‘well positioned’. In addition, recent economic data if anything had been ‘a bit better’ than expected. The Governing Council judged that while the strength of GDP in Q1 was inflated by front-loading and the exceptional performance in Ireland, domestic demand had also been strong.

Having said this, the ECB also noted that ‘the environment remains exceptionally uncertain, especially because of trade disputes’. Indeed, we note that the ECB’s baseline scenario assumes that the current 10% US tariff on imports from the EU would hold, while recent reports suggest that a US-EU deal could involve a 15% tariff (though the effective tariff rate will depend crucially on the sector-level tariff agreements). In the ECB staff’s alternative scenario that assumed a higher tariff, inflation ends up lower in the medium term. Though the Governing Council seems divided on this point, with Ms Lagarde noting that the inflationary impact of tariffs on inflation was unclear, given that there might be forces in both directions.

We think the ECB still has more to do, with the next rate cut expected in September, and likely one last cut in Q4. This reflects that we expect the economy to slow in the near term on the tariffs, while the drivers of the inflation undershoot (a strong euro and lower oil prices) may actually intensify, extending the period of below-target inflation. However, the risks are clearly shifting, and the Governing Council may well opt to look through the tariff induced weakness if it is confident enough that domestic demand will overwhelm the weak external sector. In particular, the boost from government spending may come through earlier than previously expected. Signs that an economic recovery is materialising may make the ECB more confident of an eventual return to target even if the period of below-target inflation is extended.