The European Central Bank is almost certain to reduce interest rates again on Thursday and indicate further easing in 2025 as inflation across the eurozone nears its target and the economy shows signs of weakening.
Having already cut rates in three of its last four meetings, the ECB now faces the question of whether its policy easing is sufficient to support an economy at risk of recession, grappling with political instability and the looming threat of a new trade war with the United States.
This issue is expected to dominate Thursday’s meeting. However, policy hawks, who maintain a solid majority on the 26-member Governing Council, are likely to approve a modest 25-basis-point cut, bringing the benchmark rate to 3%, according to nearly all economists in a Reuters poll.
To appease more dovish members, the cut may be accompanied by changes to the ECB’s guidance, emphasizing that additional easing will be implemented unless new inflationary shocks arise. Inflation is expected to ease toward the central bank’s 2% target in the first half of 2025.
Danske Bank economist Piet Haines Christiansen argued, “Given the already restrictive policy stance, deteriorating growth outlook, and inflation at target, a 50-basis-point cut would make sense.” However, he added, “From a communication perspective, a 25-basis-point cut would be easier, leaving room for a larger reduction if necessary.”A rate cut is justified, as new projections are expected to show inflation, which has been above target for three years, returning to 2% in the coming months. This is partly due to sluggish economic growth across the 20 eurozone countries.
The economic outlook is fraught with risks, leading some policymakers to argue that the ECB could risk falling short of its inflation target, as it did for nearly a decade before the pandemic. They believe the bank should act more swiftly to avoid falling behind.
However, hawkish members contend that inflation remains a concern, citing rapid wage growth and rising service costs, and thus argue for a steady approach with incremental changes.
Additionally, U.S. protectionism and political instability in France and Germany are further reasons for caution.
Members of the Governing Council are uncertain about the policies that will be introduced by President-elect Donald Trump’s new administration, how Europe will respond, or what the economic repercussions will be. The political instability in France and Germany’s upcoming election only add to the uncertainty, potentially forcing the ECB to intervene. This reinforces the argument that the bank should leave room for bold action if necessary, while keeping its options open for now.
“There is a significant risk that, as a result of Trump, France, and Germany, eurozone growth will be much weaker than the ECB’s projections suggest,” said ING economist Carsten Brzeski.
He added, “The issue for the ECB in preemptively responding to current political challenges is that it could be seen as intervening in national politics on behalf of France.”STRING OF CUTS
Financial markets have fully priced in a 25-basis-point rate cut on Thursday, with the likelihood of a larger reduction now close to zero. This marks a significant shift from just a few weeks ago when a 50-basis-point cut seemed like a realistic possibility.
Investors are now anticipating a rate cut at every meeting until June, followed by at least one more reduction in the second half of 2025, bringing the deposit rate to at least 1.75% by the end of the year.
Any changes to the ECB’s future guidance are likely to be subtle.
It might remove its reference to needing a “restrictive” policy stance to control inflation, signaling that rates will fall to the so-called neutral level, where they neither stimulate nor restrict economic activity.
However, “neutral” is an ambiguous concept, and each policymaker has a different estimate of where it lies, with estimates ranging from 1.75% to 3%, though most see it between 2% and 2.5%.
The ECB is likely to keep its guidance vague, having previously faced challenges when making explicit commitments that were difficult or impossible to uphold.
“With inflation expected to reach the 2% target next year, we believe the ECB will soon drop its reference to maintaining ‘sufficiently restrictive’ rates,” said UBS economist Reinhard Cluse.
“We also expect the ECB to cut rates by 25 basis points at each of the next four meetings, bringing the deposit rate to the broadly neutral level of 2% by June.”
