ECB: Heading Towards Neutral
The European Central Bank (ECB) has cut its deposit facility rate by 25 basis points to 2.75%, amid disappointing growth in the region. While inflation is projected at target this year, from a risk management perspective a level of 2.75% means upside shocks to inflation can potentially still be addressed by a slower pace of rate reductions going forward, while the rate cut offers additional protection against downside risks. In short, the ECB retains plenty of room to manoeuvre.
Since December, the ECB is no longer aiming for sufficiently restrictive policy, but rather intends to deliver an “appropriate” policy stance. As a result, discussion about a suitable neutral policy rate configuration has gained traction. ECB models previously placed the median neutral interest rate for the currency area between 2% and 3%, and, while not providing numbers today, ECB President Christine Lagarde made mention of a neutral policy range of 1.75%–2.25% in Davos last week.
Given uncertainty around the neutral policy range and still too high domestic inflation, policy rates are likely to continue their descent in a gradual fashion. Market pricing for a terminal rate of around 2% remains broadly consistent with our estimates for a neutral policy rate. Nevertheless, we see additional downside risks to growth, particularly in light of tariff threats from the new U.S. administration, and scope for lower terminal rates than currently priced in.
In terms of investment implications, as inflation has largely normalized, duration has regained its risk-hedging characteristic. High quality fixed income looks attractive, European duration offers reasonably priced downside mitigation, and we remain overweight. As for the European interest rate curve, we continue to expect the back end of the interest rate curve to underperform shorter- to-medium maturities due to rate cuts and rebuilding term premia. With the ECB’s balance sheet shrinking, investors are likely to demand additional compensation for investing in longer maturities.
The growth outlook remains weak, inflation on track
Growth in the euro area stagnated in the fourth quarter, and surveys suggest a similar picture going forward. Despite a small uptick in January, the preliminary euro area composite PMI index remains close to the 50 threshold, indicating continued economic sluggishness. More broadly, incoming data increasingly raise the question of what might drive the projected economic expansion.
None of the demand components have yet shown the strengthening foreseen in consecutive ECB staff projections. Particular question marks surround consumption-led growth in economic activity in the projections, with the data instead pointing to a substantial increase in the saving rate and a decline in consumer confidence. In addition, firms might continue holding back on investment, which could contract further in the first half of 2025.
With regard to price developments, incoming information suggests a disinflationary process is on track. Headline and core inflation came in at 2.2% year over year (YoY) and 2.7% YoY in 4Q respectively – both 0.1 percentage points below the December staff projections. On a monthly basis, headline inflation increased 0.2 percentage points to 2.4% YoY in December, with the increase driven by energy base effects.
Domestic inflation, which closely tracks services inflation, remains high at around 4%, mostly because wages and prices in certain sectors are still adjusting to past inflation with a delay. Wage growth has been moderating recently, and is expected to slow considerably this year, towards growth rates broadly compatible with the ECB’s price stability target.
Reassuringly, most measures of underlying inflation continue to suggest that inflation will settle near the 2% medium-term target. The ECB’s Persistent and Common Component of Inflation (PCCI) measure (which is deemed to have the best predictive power for headline inflation over a one- to two-year horizon) has hovered around 2% for over a year.
Featured Participants
Disclosures
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.
CMR2025-0130-4204073