ECB likely has more to do, despite hints it is nearing the end
The ECB’s Governing Council decided to cut its policy rates by 25bp, taking the key deposit rate to 2%. The move was widely expected by analysts and priced in by financial markets. The comments in the press conference suggested that the Council considers it is nearing the end of its rate cut cycle. However, we think that further interest rate cuts are still likely. Indeed, we maintain the view that the ECB will cut policy rates further, with the deposit rate reaching 1.5% by September. The ECB’s more hawkish tone does raise the possibility that the rate reductions may take longer than that to materialise, with a pause possible at the next meeting.
Following the rate cut, ECB President Christine Lagarde explained that ‘at the current level of interest rates, we believe that we are in a good position to navigate the uncertain conditions that will be coming up’. In addition, she noted that ‘we are getting to the end of a monetary-policy cycle that was responding to compounded shocks’. Furthermore, Ms Lagarde also stressed that the undershoot in inflation that the ECB was projecting in the coming quarters was largely due to lower energy prices and the euro and that inflation would return to 2% in 2027.
Having said all that, the Governing Council continued to stress that ‘especially in current conditions of exceptional uncertainty, we will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance’. And the details behind its macroeconomic projections imply that it may well need to do more. For instance, its forecasts are based on market interest rate expectations, meaning that they are predicated on some further easing.
In addition, some of the forces pushing down on inflation might be stronger and more persistent than assumed. It assumes that the euro would flatten out at around 1.13 against the dollar. However, its sensitivity analysis shows that further euro strength (+3% baseline in 2026 and 5.5% vs baseline in 2027) could see inflation 0.2 pp lower in 2026 and 0.3 pp lower than baseline in 2027. We think further euro strength is likely given the overvaluation of the dollar and indeed the ECB’s more hawkish tone in the press conference could encourage such a trend.
Furthermore, the Governing Council continues to see risks to the economic outlook as being tilted to the downside largely due to the possibility of ‘a further escalation in global trade tensions and associated uncertainties’. The staff presented alternative scenarios together with its baseline scenario where trade tensions either escalate or deescalate. Crucially, it notes that ‘a further escalation of trade tensions over the coming months would result in growth and inflation being below the baseline projections’. This is a departure from its previous view that the impact on inflation of escalating trade tensions was uncertain. In its Severe scenario, where the effective tariff rate on US imports from the euro area rises to 20%, GDP would be ‘cumulatively about 1 percentage point below GDP growth in the baseline, with inflation at 1.8% in 2027 compared with 2.0% in the baseline’.