The European Central Bank (ECB) is widely expected to reduce interest rates on Thursday, with the possibility of further cuts on the horizon as economic growth within the eurozone continues to underperform. Despite inflation concerns lingering, economic stagnation is now the central issue driving ECB policy decisions, making a rate cut almost inevitable.
The ECB’s decision to lower borrowing costs four times last year was driven by the belief that inflation had surged to levels unseen in decades. However, as inflationary pressures seem to be easing, the European economy is struggling, particularly due to a decline in industrial output and sluggish consumer spending. This weak economic performance has prompted widespread expectations that the ECB will deliver further monetary easing in 2025, possibly by up to four more cuts.
The argument for a rate cut is so strong that none of the ECB’s 26 policymakers have opposed it publicly. The eurozone is still grappling with an industrial recession, which has led to persistent economic contraction in key sectors. With this backdrop, the ECB is expected to cut its deposit rate by 25 basis points, bringing it down to 2.75%, its lowest since early 2023. This would follow the United States Federal Reserve’s decision to pause its rate-cutting cycle on Wednesday, further highlighting the contrasting challenges central banks are facing.
Christine Lagarde, President of the ECB, is unlikely to provide any definitive statements about future cuts, but she is expected to underline that the policy trajectory remains clear. Lagarde may also highlight the threat posed by a potential trade war between the US and Europe, which could dampen already weak economic growth.
According to economist Jan von Gerich from Nordea, inflation in the eurozone is moving closer to the ECB’s target of 2% in a sustainable manner. However, the economic outlook remains fragile, and interest rates are still in restrictive territory, meaning further easing could be necessary. “The process of gradual normalisation remains incomplete,” von Gerich explained.
While inflation dipped to 2.4% in December, it still requires a few months to return to the ECB’s 2% target. This steady decline in inflation, combined with moderating wage growth and a cooling labour market, suggests that inflationary pressures are being effectively managed. The easing of oil prices and a pause in the dollar’s strengthening have also contributed to this optimistic outlook.
However, certain sectors remain vulnerable. Services costs continue to rise, albeit gradually, and could pose a challenge for the ECB in its quest for a more sustainable inflation trajectory. While these concerns are valid, they are unlikely to prompt the ECB to halt its rate cuts entirely. Instead, policymakers will likely opt for a cautious, incremental approach to rate adjustments.
Looking ahead, there is growing debate about how much further the ECB can go with rate cuts. While the central bank is expected to reduce its deposit rate to around 2.75%, this would be approaching the neutral range of 1.75% to 2.5%, a level considered neither stimulatory nor restrictive for economic growth. However, any rise in trade tensions, particularly with the US, could add volatility to the eurozone’s already fragile economic situation, possibly leading the ECB to consider even deeper cuts to stimulate growth.
Antonio Villarroya, an economist at Santander CIB, believes there is a strong case for bringing rates closer to the lower end of the neutral range by mid-2025. The possibility of a trade war, which would escalate market volatility, could push the ECB to adopt even more accommodative monetary policies to cushion the impact on growth.
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The eurozone’s economy is characterised by weak domestic demand, high uncertainty, and restrictive monetary policies. These conditions are limiting investment and stifling the growth potential of businesses. As Mariano Cena, an economist at Barclays, pointed out, businesses are likely to continue holding back on investments, with the first half of 2025 expected to see a further contraction in industrial investment.
Yet, despite these concerns, inflation remains above the ECB’s target, and issues like poor productivity growth and labour shortages could continue to exert upward pressure on prices. These factors may limit how far the ECB can go in cutting rates without risking a resurgence of inflation.
Isabel Schnabel, a member of the ECB’s executive board and known for her hawkish stance, has already hinted that the central bank will soon need to assess how much more it can reduce rates. As the debate over the ECB’s future policy direction intensifies, policymakers will need to balance the twin challenges of supporting growth while ensuring that inflationary pressures do not resurge.
In conclusion, the ECB is set to cut interest rates in the short term, but its path forward remains uncertain. The weak economic outlook and concerns over a potential trade war with the US could shape the future of monetary policy in the eurozone, making it crucial for the ECB to remain flexible and responsive to evolving economic conditions.
