ECB preview: Trump has not changed the ECB's plans yet

Summary

Trump’s first few days in office have not materially affected the Eurozone economy yet.

However, uncertainty remains high, particularly as it relates to potential US tariffs.

We therefore expect the ECB to stick to its path of gradual cuts. Lagarde probably will not give much new direction, as the ECB seeks to preserve its flexibility to react to developments.

Policy expectations

We expect the ECB to cut the deposit rate by 25bp at next week’s meeting.

In total we still have three cuts pencilled in, to 2.25% by April. This is based on our premise that underlying inflation will be a bit stickier than the ECB expects.

For now, President Trump has not materially changed the outlook for the Eurozone economy. So, there is no reason to expect the ECB to change course at this juncture. The Governing Council increasingly expects inflation to converge to the 2% target in the course of 2025. This allows for another 25bp cut at the January policy meeting. However, uncertainty remains high. So, even though the ECB may be inclined to cut further in the coming months, we believe the ECB also wants to keep its flexibility. Lagarde will probably refrain from giving any guidance.

Policy rates: Little resistance to another cut

Most policymakers have indicated that they would support another 25bp rate cut next week, and there is little reason for the ECB to deviate from that path.

It’s been only a couple of days since Trump has taken the highest office in the United States, and he has already signed a plethora of executive orders. However, so far, the US president has not yet acted on his threats to raise tariffs on imports from many, if not all, countries. Thus, the ECB will probably see its December projections as still being valid, and we doubt that any of the policymakers will take a substantially different view on inflation when they next meet.

Arguably, today’s PMI data were somewhat better (read: less bad) than expected, with a marginal expansion of activity and stabilisation of the employment outlook. In other words, the outlook remains weak, but at least it isn’t deteriorating. This should invalidate any suggestions of a bigger, 50bp rate cut in order to support economic activity. And at the same time, the PMI survey indicates that input costs accelerated sharply in January, as did selling prices. That will not block further cuts for now, but it should keep the ECB somewhat cautious going forward.

In summary, the incoming information suggests that the path of continued, but gradual, rate cuts is still the best route in the eyes of the Governing Council. That is, another 25bp cut in January.

Table 1: Policy rate expectations by meeting

Risks of delays, but also risks of being cut short?

We still believe further cuts are likely to materialise in the subsequent meetings, as the ECB appears to be targeting a 2% to 2.25% neutral rate. However, the Governing Council wants to preserve some ambiguity and flexibility to respond to future developments, so we don’t expect much in the way of new guidance from Lagarde next week.

Although little to no members of the Governing Council seem to aim for an expansionary policy stance at this juncture, a very large majority wants to move to the neutral rate in the coming months. Opinions of that exact neutral rate differ amongst the various policymakers, but they are largely centred around the low-2% area.

As we’ve noted previously, discord within the Governing Council will probably increase the closer the ECB gets to what the various members believe to be the exact neutral point. The next one or two cuts should face little to no resistance, but after that, a number of hawks may believe that the neutral rate has already been reached.

Back in December, our call for a 2.25% endpoint was still a hawkish outlier. But since then, the market has shifted dramatically in our direction. In fact, the market no longer sees an April rate cut as a given. Instead, ECB-dated forwards currently only fully price the third rate cut this year by June.

We are cognizant that fundamental uncertainty about the neutral rate, as well as lingering uncertainty about the final leg of the disinflationary process are a risk to our forecast of back-to-back cuts through April. Policymakers are increasingly confident that inflation will return to target in the first half of 2025. Still, the dynamics of services inflation remain a particular topic of debate in the Council. Some policymakers take a benign read-across from the recent deceleration, while others are worried this may be due to statistical anomalies. We still see the remaining gap between underlying inflation and the ECB’s target close more slowly than the Governing Council seems to anticipate. If this convergence is too slow to the ECB’s liking, the central bank could still opt to delay the cut we have pencilled in for April until June.

However, more so than the risk of delays, we see the risk that the ECB’s intended cycle to (about) 2% could be cut short. Much hinges on the policies of the new US administration, and just because Trump has not acted on his threats yet, that does not mean that he will not impose tariffs on Europe or other countries. We concur with Mrs. Schnabel, who recently said that she thinks a trade conflict with the US administration is “very likely.” While that may hurt growth, we believe that this would also lead to higher inflation. At least some within the ECB seem to be of that view as well: in the December meeting, “attention was drawn to the prospect of substantial supply and demand shocks on the horizon,” for example due to geopolitical risk or climate and nature crisis that may create bottlenecks in the productive capacity of the economy.