ECB remains on a gradual path towards the neutral rate

The incoming data have largely developed as the ECB expected, which paved the way for another rate cut.

Data released this morning indicate that Eurozone GDP had stagnated in Q4. In fact, both the German and French economies shrank last quarter. But Lagarde broadly shrugged this off, noting that the recovery was “certainly” still ongoing.

Likewise, the slight uptick in Eurozone inflation “had been expected” by the Governing Council, and policymakers remain confident that inflation will reach the 2% target in the course of 2025. Lagarde acknowledged that domestic services inflation remains high, but she added that this is largely due to lagged adjustments of wages and prices. The policy statement optimistically notes that “wage growth is moderating as expected, and profits are partially buffering the impact on inflation.”

But the coming few inflation prints are critical for the ECB’s confidence: at the start of each year, various sectors update their price lists, and the Governing Council is closely monitoring the price hikes in those sectors that were also the last to respond to the inflation surge. She suggested that the ECB expects to see lower price pressures in these sectors, compared to last year. If these sectors bump prices by more than expected, that could invalidate the ECB’s hypothesis that the stubbornness of services inflation is largely due to catch-up effects.

With the economy largely developing as forecast, the ECB still seems on track for gradual cuts towards neutral. Where the ECB expects this to be exactly, we may learn on February 7.

As noted above, the central bank believes that the conditions for economic recovery remain in place. In fact, the ECB’s growth outlook is pretty similar to ours. Policymakers expect consumption to pick up, which should support economic activity. Furthermore, Lagarde noted that exports could be a potential, additional engine for growth – provided that trade tensions do not escalate. That is a big if. But more importantly, she essentially suggested that the ECB’s growth forecasts are at least somewhat robust for any tariffs, considering that exports are not seen as a main driver.

The ECB’s fairly constructive view of the economic outlook suggests that policymakers do not see any immediate need to move the dial beyond neutral and into an accommodative policy stance.

Lagarde recently gave a slightly updated estimate of the neutral rate. At the World Economic Forum, the ECB President cited a range of 1.75% to 2.25%. That’s slightly narrower than the upper bound of 2.5% she mentioned at one of the press conferences. Asked why she had changed this, she noted that ECB staff have been working on a research paper on the neutral rate. She added that this will be published on February 7, and it will certainly inform the Governing Council’s future discussions. The slightly narrower range cited by Lagarde, suggests that this will also be the gist of the paper. If so, this could reinforce market speculation of a 2% terminal rate.

Although a 2% neutral rate would be a plausible estimate, we maintain our forecast of a 2.25% terminal rate for now. The ECB is gradually heading to this neutral rate, but we continue to see some lingering inflation risks that could stop the ECB at the upper end of their neutral range.

In contrast to the impact on Eurozone exports and GDP, Lagarde did not want to say whether the ECB mainly expects a trade conflict with the US to be inflationary or disinflationary. She only noted that it makes the inflation outlook more uncertain. There is simply too little information on the potential scope of any tariff, whether the same rate is applied to all countries, whether this leads to trade rerouting, and whether there are any retaliatory measures. So only when Trump imposes a clear tariff, can and will the ECB capture its impact.

However, in their assessment of the risks to the inflation outlook, the ECB considers geopolitical risks as an upside risk to prices. Lagarde explained that this could lead to higher energy and freight costs, and that it could disrupt trade. By extension, if one assumes that tariffs may also be disruptive to trade, this suggests that the ECB should also conclude that tariffs are more likely to be inflationary than deflationary.

Our own models also suggest that tariffs would probably add to price pressures in the Eurozone – albeit to a lesser extent than in the US. In fact, our forecasts already include placeholder tariffs. Our forecasted inflation miss in 2026 (2.3%) can almost fully be traced back to the impact of US trade tensions.

Besides these contingent inflationary pressures, we note that energy prices and the prices of some agri commodities have recently increased. And in recent surveys, companies also reported renewed increases in input costs and selling prices. This adds some new upside risks to the ECB’s inflation outlook, in our view. Altogether, these lingering inflation risks support our view that the ECB may be forced to stop at the high end of the estimated neutral range.