ECB: It Will Get Harder From Here

The European Central Bank (ECB) cut its deposit facility rate by 25 basis points from 2.75% to 2.5% without opposition among its Governing Council members, and only one abstention from the vote.

Its new staff projections show lower growth expectations and a broadly unchanged inflation outlook. Weak growth and inflation projected at target argue for a policy rate close to neutral, despite still elevated domestic inflation.

Accordingly, the ECB no longer aims for overly restrictive policy but intends to deliver an “appropriate” policy stance. Discussion about the eventual landing zone has gained traction. At the Davos World Economic Forum in January, ECB President Christine Lagarde cited a 1.75–2.25% neutral policy range, based on ECB staff research. However, disagreements have since emerged, and elevated uncertainty is complicating the analysis. It is the data flow that will eventually be the deciding factor in the decision to cut or pause rates at upcoming meetings, and decisions are likely to be more contentious.

Executive Board (EB) member Isabel Schnabel downplayed the relevance of the neutral range estimates, made the case for a higher neutral rate, and questioned whether monetary policy is still restrictive. She also believes a pause in the rate-cutting cycle should be discussed soon. In contrast, EB member Piero Cipollone not only thinks that the current policy setting is overly restrictive, but also urged the ECB to ensure that rate decisions adequately compensate for the tightening induced by the reduction of the balance sheet.

For now, we think policy rates are likely to continue their descent in a cautious fashion, and believe the ECB is not done yet with cutting rates. Market pricing for a terminal rate of around 2% seems reasonable, and remains broadly consistent with our estimates for a neutral policy rate for the euro area. We see downside risks to already weak euro area growth in the near term, mainly on the back of uncertainty around trade; while fiscal measures related to defense and infrastructure should support growth in the medium- to longer-term.

Investment implications

Our highest conviction view is for a steeper interest rate curve. We continue to expect the back end of the interest rate curve to underperform shorter- to medium-term maturities due to rate cuts and rebuilding term premia. With the ECB’s balance sheet shrinking and additional fiscal stimulus, investors are likely to demand higher compensation for investing in longer maturities.

Economic growth remains weak …

The euro area economy continues to stagnate, growing well below trend. In February, the composite Purchasing Managers' Index (PMI) remained at 50.2 points, disappointing expectations. Coupled with January’s PMI print, this seems consistent with growth of around 0.1% quarter-on-quarter. The ECB lowered its growth projections once again, and continued to characterize risks to growth as tilted to the downside. The March staff projections see growth at an average: 0.9% in 2025; 1.2% in 2026; and 1.3% in 2027.

Incoming data continue to ask the question of what should drive the projected economic expansion, as none of the demand components has shown the decisive strengthening foreseen in consecutive ECB staff projections. Particular question marks surround the consumption-led growth in economic activity in the projections, with the data pointing to an elevated savings rate and weak consumer confidence instead.

Investment is unlikely to materially pick up near term, while increased German infrastructure spending should be supportive in the longer run. Similarly, scaling up European defense capabilities will help growth medium- to longer-term. However, given the high import content as of today, the growth multiplier on this type of spending might turn out to be rather low.

… while inflation is projected at target this year

The disinflation process remains on track, and inflation has developed broadly in line with previous staff projections. The ECB expects headline inflation to average 2.3% in 2025, 1.9% in 2026, and 2.0% in 2027, while core inflation is expected to average 2.2% for 2025, 2.0% for 2026 and 1.9% for 2027. The ECB’s 0.2 percentage point upward revision for 2025 headline inflation was driven by stronger energy price developments, and implies the ECB will achieve its 2.0% inflation target in Q1 2026 instead of Q4 2025.

For inflation to evolve in line with ECB expectations and durably converge to target, growth in unit labour costs falling back to levels that are broadly consistent with 2% inflation remains the most important prerequisite. Services inflation is still elevated, at 3.7%, and a sustainable decline requires additional deceleration in wage growth, even more so as productivity might continue to disappoint.

Wage growth has been moderating as of late, and is expected to slow considerably further this year, towards the 3% area. Most measures of underlying inflation suggest that inflation will settle at around target on a sustained basis. The ECB’s Persistent and Common Component of Inflation (PCCI), deemed to have the best predictive power for headline inflation over a one- to two-year ahead horizon, has been around 2% for more than a year.