Overview
The opening monetary policy meetings of 2025 saw the European Central Bank move on quickly with the cuts in interest rates vitally needed by a struggling economy, while the US Federal Reserve held fire. The outlooks for both banks are clouded by uncertainty over President Trump’s exact course on trade tariffs and their impact on inflation and, particularly in Europe, growth.
Fed paralysed by policy doubts
The Federal Reserve maintained its policy rate at 4.25-4.50 per cent as widely expected, the first pause since it began cutting rates last year as the committee navigates an increasingly complex economic environment.
Notable modifications to the statement included an upgrade to its assessment of labour markets, shifting from characterising conditions as having "generally eased" to having "stabilised" – a reflection of the strong December employment report. While the statement also removed a prior reference to continuing progress on inflation, now stating inflation “remains somewhat elevated”, Chair Jerome Powell significantly de-emphasised this change in his press conference, suggesting it was merely a “clean up“ of the language.
The meat of the press conference suggested ongoing caution regarding the inflation trajectory, with Chair Powell studiously avoiding answering any questions on tariffs. While he stressed that the committee was now no longer in a “hurry” to cut, his own views were more dovish. For instance, he reiterated that current policy remains "meaningfully restrictive”, and that his preference is to cut if either labour market or inflation data warranted it.
As a result, the market seesawed between an apparently hawkish committee statement, and a chair whose preference seems to be for further cuts. In our view, this tension will ultimately resolve itself when the Fed is able to start incorporating actual administration policy into its expectations.
We expect a policy cocktail of tariffs and significantly reduced immigration to keep inflation elevated. A labour market that is now stabilising rather than softening reinforces our view that the committee will maintain current policy settings through 2025, prioritising policy stability over premature adjustments.
ECB eyes further easing
The ECB’s quarter-point cut in its main policy rate to 2.75 per cent was similarly in line with expectations and the accompanying statement remained largely unchanged. Emphasis remains on its data-dependent approach and meeting-by-meeting assessment.
The Bank continues to deem its current stance as restrictive, signalling further cuts are coming until it reaches neutral. Market participants have largely aligned with the ECB's assessment that neutral rates are around 2 per cent. However, we see an increased likelihood of cuts into accommodative territory given the challenging growth outlook.
While no new economic forecasts were released at this meeting, recent data backs this view: Q4 GDP growth came in flat at 0.0 per cent, below the ECB's previous projection of 0.2 per cent, reinforcing the downside risks.
On the inflation front, both headline and core measures ended Q4 lower than anticipated, but President Lagarde highlighted potential inflationary forces stemming from stickier wages and tighter supply chains on the back of greater global trade frictions. Higher energy prices and currency depreciation are additional upside risks in the near term. However, President Lagarde stressed that the disinflationary trend is “well on track”.
The latest Bank Lending Survey revealed a further tightening in credit conditions, primarily driven by banks' heightened risk perception amid trade policy uncertainty, while continued weak lending growth further strengthens the case for additional monetary easing.
Looking ahead, we expect the ECB will maintain its current pace of rate cuts until it reaches that neutral rate of around 2 per cent, followed by a more gradual approach with cuts at alternate meetings. Our view remains more dovish than the current market pricing, as we expect pressure on growth to push the terminal rate to 1.5 per cent by year-end, mostly due to persistent concerns over global trade tensions. We expect to see developments on the tariff front in coming weeks. This will be a critical driver of ECB policy going forward.
