Overview
The European Central Bank (ECB) cut its policy rates by 25 basis points (bp) at today's meeting, bringing the deposit rate to 2.5 per cent, in line with expectations. But the Governing Council finds itself at a crossroads.
How will recently announced fiscal stimulus affect ECB policy? There are several disinflationary factors at play. Potential growth, that is the maximum rate at which the eurozone economy is capable of growing, is likely increasing. That makes stronger growth less inflationary.
A lot of the increased defence spending meanwhile will go on imports, reducing the economic multiplier effect and so limiting the potential fiscal impulse. Bund yields are surging, which is growth-negative in ECB models, and the euro is appreciating, also disinflationary.
Additionally, the timing of fiscal implementation means a meaningful positive impulse is unlikely before 2026.
The language in today’s monetary policy statement regarding the restrictive stance showed a notable shift. The ECB states "monetary policy is becoming meaningfully less restrictive," signalling they recognise the transition away from a tight policy stance is well underway.
Updated staff projections show a slight downgrade to near-term growth, minor changes to core inflation, and mechanically higher headline inflation for 2025, reflecting mostly the rise in energy prices between projection rounds. The Governing Council maintained that the disinflation process is "well on track" and noted that "most measures of underlying inflation suggest that inflation will settle at around the Governing Council's 2 per cent medium-term target on a sustained basis." They acknowledged that "domestic inflation remains high," but emphasised that "wage growth is moderating as expected."
Looking ahead, the ECB stating it now sees interest rates as "meaningfully less restrictive" was a strong hint that they could pause at the next meeting. We therefore now see April as a 50/50 decision that will depend heavily on incoming data and whether President Trump's anticipated tariff announcements on April 2nd include significant measures targeting Europe.
We now anticipate the ECB will aim for the lower end of the neutral range (around 1.75 per cent) rather than moving into accommodative territory. This reflects our view that while fiscal announcements give the ECB room to potentially pause in April (barring aggressive tariffs on Europe), they will still want to position monetary policy to support economic recovery given ongoing downside risks from potential trade disruptions.
Markets are now pricing in less than two more cuts this year and a terminal rate of around 2.1 per cent, so we maintain a more dovish outlook, though not as dovish as before this week's fiscal announcements.
