ECB preview: Back-to-back cuts to (around) neutral?

Heading into the December meeting, another 25bp rate cut is pretty much a given. Money market pricing has downgraded the probability of a 50bp cut to unlikely, but traders continue to price a return to expansionary policy in the course of 2025. We still see hurdles preventing that.

In the past couple of months, policymakers have grown more concerned about the growth outlook, although the level of concern varies between the individual members of the Governing Council. At the same time, most, if not all, of the ECB’s rate setters will agree that policy rates are still in restrictive territory. So, another 25bp rate cut should find unanimous support in the Governing Council.

A minority of the more-concerned policymakers may prefer a 50bp reduction, but we don’t see this pass the Council. First of all, a larger cut may suggest greater urgency, or even panic, on the ECB’s side – particularly given that the market is only pricing a small chance of this materialising. As a result, the impact on confidence could offset the intended effect of a larger cut. Secondly, the staff projections will probably look less grim than some of the policymakers believe the outlook to be. We fully expect the growth forecasts to be revised lower, but not dramatically so. And at the same time, inflationary risks haven’t fully dissipated.

Dropping the hawkish guidance

But clearly, the ECB is no longer only worried about upside inflation risks. The downside risks to the euro area economy add some downside risks to the inflation outlook as well. With risks becoming more two-sided, the policy statement no longer needs to have an explicitly hawkish bias either. Specifically, we expect the ECB to remove the guidance that the Governing Council “will keep policy rates sufficiently restrictive for as long as necessary.”

To avoid giving the impression that the ECB intends to accelerate rate cuts towards a neutral, or even accommodative, policy stance, the Governing Council may choose to substitute this with a phrase that indicates moderation. The ECB’s narrative of data-dependence will play a key role here, and we fully expect the ECB to stick to this narrative.

Back-to-back cuts to neutral

Even though the ECB will retain its “data dependence”, we believe the Governing Council is now inclined to cut at every subsequent meeting until the deposit rate reaches a broadly neutral level, which we believe to be around 2.25% in April. Given the weaker growth outlook, we expect to hear little disagreement from policymakers in the coming months that the restrictiveness of monetary policy can gradually be dialled back further.

However, when the deposit rate approaches neutral, we expect to see more discord amongst the Council members again. Whereas the doves may advocate for accommodative policy to counteract growth risks, we believe that the hawks will be more reluctant to move below neutral. The weak growth outlook is largely due to structural factors, rather than cyclical weakness. Monetary policy is ill-equipped to deal with that.

What’s more, by that time, the impact of US President Trump’s policies should become clearer. We expect the Fed to stop easing in January already, on the back of US inflation. So if the ECB sets the monetary dial to expansionary again, rate differentials will only increase and the currency may only weaken further – adding to the costs of imported energy, for example. Moreover, our own scenario analysis indicates that trade tensions will predominantly lead to higher inflation, not lower growth, in the euro area. So the scope for policy easing from around mid-2025 should be limited. Based on our forecasts for growth and inflation for the coming two years, our Taylor rule suggests that 2.2% is roughly the appropriate policy stance by the end of next year (see Table 2).

We fully expect the ECB to end the PEPP reinvestments at the end of the month. We estimate that PEPP redemption flows could increase from €7.5 to around €15 billion per month.

Exactly one year ago, in December 2023, the ECB first communicated its intention to discontinue reinvesting maturing bonds held in the PEPP portfolio at the end of 2024. To this day, the ECB still states that “the Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.” So a decision is due, and we fully expect the ECB to stop these reinvestments. The ECB has given long enough notice, which should limit the market reaction

Still, some may argue that the timing is not ideal, and Lagarde may have to do some PR. French spreads are under pressure from the political uncertainty in the country. And the cheapening of repo rates relative to €STR suggests that there is an abundance of sovereign paper. However, neither is a primary objective of the PEPP, so if the ECB shares any of these concerns, they will probably use dedicated tools to address the issue. If French widening would lead to any contagion, the ECB can still resort to (the threat of) the Transmission Protection Instrument, which was invented specifically to counteract unwarranted spread widening. And if the ECB believes that enough liquidity has been drained through QT, policymakers have indicated that they will create a new structural portfolio that is separate from the previous asset purchase programmes. We don’t think that excess liquidity is approaching that level yet, though.

PEPP redemption flows to double?

Recall that the ECB has already started to shrink the PEPP portfolio gradually since July, when it started to reduce its holdings at an average pace of €7.5 billion per month. The ECB currently only reinvests the redemption flows that exceed this €7.5 billion threshold. We guesstimate that PEPP redemption flows could increase by €7.5 to €10 billion per month from January, to a monthly average of about €15 to €17 billion.

The ECB has provided relatively little transparency regarding its PEPP portfolio. For example, the central bank provides estimates of the monthly redemption flows for its APP portfolio, but not for the PEPP holdings. For the 2025, the ECB expects the APP portfolio to shrink by €334 billion, of which €253 billion in sovereign and supranational bonds.

We do know that sovereign bonds make up 97% of the PEPP portfolio, for a total amount of €1568 billion. By comparison, the sovereign holdings under the APP amount to €2143 billion. The weighted average maturity of PEPP holdings is 7.18 years as at end-November, which is broadly comparable to the APP portfolio (6.9 years). So adjusting the APP redemption flows for the smaller size of the PEPP, we end up at a rough estimate of €185 billion in PEPP redemptions for 2025, or €15 billion per month. The omission of corporate debt from this estimate may lead to a somewhat higher realisation, whereas the longer weighted average maturity for the PEPP indicates that redemptions could be a little lower than this figure.

The updated staff projections will probably feature a weaker growth outlook, and the forecasts may see convergence with the 2% inflation target somewhat sooner in 2025. However, we argue that incoming inflationary pressures may be underrepresented due to the way the staff forecasts are constructed. We see a more stagflationary picture emerging.

Weak growth ahead

Since the release of the September projections, the growth outlook has clearly deteriorated. We cannot repeat often enough that Germany’s economic model – which used to rely on cheap Russian gas, endless Chinese demand, and a US security umbrella – is fundamentally broken. The manufacturing sector is still struggling with these structural issues, and uncertainty about external demand – not only from China but also from the US – is weighing on manufacturers’ willingness to invest. Meanwhile, fiscal budgets have thrown both the German and the French government in limbo. According to our own updated projections, these headwinds will weigh on euro area growth: we’ve lowered our forecasts for 2025 and 2026 by respectively 0.2 and 0.1 percentage points. The consensus amongst our peers is still slightly more optimistic, but either way the ECB projections look due for a downward revision.

Stubborn inflation

On the back of weaker demand, the ECB staff may bring forward the date when they predict inflation to return to 2% from 2025Q4 to somewhat earlier in the year. At the October meeting, policymakers already expressed some optimism that inflation would decline to target “in the course of next year,” which suggests a shorter timeline than “in the second half of next year.”

We are less convinced that inflation will swiftly converge to 2% after the turn of the year. The progress to date has almost fully been driven by goods prices, but services inflation remains stubborn. That’s partly a reflection of past wage increases. We don’t believe the rebound in negotiated wages –to the highest rate since the inflation shock– will be sustained, especially with the weaker outlook for manufacturing. However, the labour market remains tight, even if weaker growth leads to less labour hoarding. In our recent discussions with corporate clients, many indicated they were still seeing price pressures. Overall, clients expect that wages and cost pressures will stay elevated in the foreseeable future. The PMI surveys corroborate this to some extent: in November input costs accelerated to the highest rate since August.

Meanwhile, the recent depreciation of the EUR also adds to the costs of imported energy and materials. Our FX strategists forecast this weakness to persist in the coming months, and we see EUR/USD drop to parity on a 6 month basis. For now the impact – especially on a trade-weighted basis – would seem modest, but additional volatility in this space could draw more attention to the FX market.

The inflation risks unaccounted for

The ECB may have a different opinion on these inflation dynamics, but these drivers will be embedded in the upcoming set of projections. However, we see an additional driver of inflationary pressures that the ECB staff probably will not account for: Trump.

Arguably the outlook for US policy has become clearer. Trump is now president-elect, and we can tear up the economic scenarios based on Harris’ policy agenda. But although the general direction of Trump’s agenda is clear, his exact policies are still unknown. The staff projections generally do not include assumptions about upcoming policy changes, such as tariffs or a further deterioration of the geopolitical landscape.

By contrast, our forecasts do account for the expected impact of Trump’s policies (or, a plausible interpretation of his agenda). According to our econometric models, the impact on growth should be fairly limited – and the recent slide in EUR/USD effectively mitigates the impact of any tariffs on European exports. However, virtually all of the inflation overshoot we forecast for 2026 can be traced back to the impact of the president-elect’s policies and Europe’s response. That’s especially the case if Europe retaliates with tariffs against the US, or if Europe is forced to increase anti-dumping measures against, e.g., China. On top of that there is also a plausible upside scenario where Europe does accelerate investments in defence, its industry and the energy transition. The political will may yet be lacking, but the plans are on the shelf; market volatility or another outside shock could be one of the missing ingredients for a drastic paradigm shift in Europe.