The ECB will cut its deposit rate to 2.75% at its meeting this week. Although inflation has been more resilient than expected, activity in the euro area remains weak, which will continue to push inflation towards the ECB’s target.
The most recent forecast shows the ECB will hit its 2% inflation target this year and President Christine Lagarde’s latest statements suggest the ECB’s executive board is increasingly confident this will happen. As a result, it is very likely the ECB will cut this week and in March.
After the March meeting, financial markets are less certain about the ECB’s cutting path. The current market pricing allows for the possibility the ECB will slow down the cutting cycle to quarterly from the current sequential pace. There are concerns the ECB will become less determined to cut rates the closer the deposit rate moves to 2% – the neutral rate – at which monetary policy neither restricts nor stimulates the economy.
Our view is that economic data will continue to push the ECB to cut at every meeting until the deposit rate reaches 1.5%. Trade policy uncertainty remains very high, especially with the new US administration’s assertive approach to tariffs. This means many firms will pause investment decisions until the major changes in trade policy are resolved. This will keep activity weak for the foreseeable future.
With respect to inflation, US tariffs on China could further add to global spare capacity in traded goods. Goods disinflation from China will likely lead to weaker-than-expected core CPI inflation in the euro area in the second half of the year. There are risks inflation undershoots the ECB’s target in the second half of the year. These two factors together, weak activity and disinflation, will likely surprise the ECB. As a result, the ECB will likely continue to cut interest rates at every meeting this year, until the deposit rate reaches 1.5%.
By Tomasz Wieladek, chief European economist at T. Rowe Price
