The ECB can cut its rates further

In one year, the ECB has reduced its main interest rate from 4% to 2.25%. In April, it removed the wording that "monetary policy is becoming significantly less restrictive". By stating that "there is no better time to be dependent on data" and suggesting that the near-term risks to inflation are balanced, it seems to us that the ECB is trying to buy some time, while waiting for new forecasts in June.

At the April meeting, Christine Lagarde highlighted the downside risks to growth (trade war, uncertainty, tightening financial conditions and geopolitical tensions) which could affect exports, business investment or consumption. We believe that these risks are real, that they could cut growth by a few tenths of a point of GDP this year and next, mainly because of the shock that the US and Chinese economies will suffer due to the intense tariff war they are engaged in, with rates above 125%. But this shock will be much weaker than that of COVID, when European GDP fell by nearly 6%, or that of the energy crisis when energy bills increased by 4 points of GDP. We cannot rule out a small, short-lived technical recession this summer, given the profile of our exports, but annual growth in 2025 should remain decent. The IMF has just lowered its forecast to 0.8%, as much as in 2024 and more than in 2023 (0.5%).

More surprisingly, Lagarde said that "the net impact of the tariff war on inflation will only become clear over time," also suggesting that the risks to inflation are balanced. On the one hand, lower commodity prices, lower energy prices, the appreciation of the euro and the expected reorientation of global excess supply could put downward pressure on inflation. On the other hand, the fragmentation of the global supply chain, the increase in defence spending in Europe and infrastructure spending (in Germany) could increase inflation in the medium term.

“Markets are now fully pricing in two rate cuts by July and a terminal rate of 1.50% by January 2026, but by 2027, the ECB should not take the risk of lowering its policy rates much lower than these levels.”.

We view all recent developments as slightly disinflationary over the next twelve months. We expect inflation to fall from 2.1% year-on-year in April to 1.6% by the end of the year, mainly due to lower oil prices and the appreciation of the eurodollar. As for core inflation, it remains a little high, at 2.6% year-on-year. However, collective wage bargaining suggests that wage growth will rise from 4.3% year-on-year at the end of 2024 to nearly 3% at the end of 2025, which should allow core inflation to move closer to 2%. In June, the ECB's new forecasts should take into account these recent developments and show an outlook on inflation close to ours.

As a result, we believe the ECB will be willing to cut its key interest rates in June and July, bringing its main policy rate down to 1.75%. Markets are now fully pricing in two rate cuts by July and a terminal rate of 1.50% by January 2026.

However, in the medium term (by 2027), caution is required. The ECB should not take the risk of lowering its key rates much lower than these levels. Potential growth is probably between 0.5 and 0.8% per year in the euro area, due to a shrinking labour force, in the absence of exceptional migratory flows, and weak productivity gains. But from 2027 onwards, growth could be significantly higher than potential growth, due to higher government spending and the possibility that political uncertainty could ease. Germany's budget deficit was 2.8% of GDP in 2024, and we expect it to increase in the coming years, freed from the constitutional constraints of the debt brake. Given its new €500 billion infrastructure investment fund and the increase in military spending, we see additional spending of 2% of GDP per year. The rest of Europe is also expected to push up military spending. There will then be significant upside risks to core inflation, which could be reinforced by persistent trade tensions.

Link to the full article published in Option Finance (In french).