Though reflationary hopes are high, disinflationary pressures are staying strong.
After 200 basis points of interest-rate cuts from the European Central Bank (ECB) from June 2024 through June 2025, the market senses a turning point and seems ready for higher rates ahead. We think one more cut could be in the offing.
Several factors have caused markets to expect higher rates. ECB President Christine Lagarde recently declared herself “comfortable” with the current inflation rate and deposit facility rate (both at 2%). Lagarde asserted that the ECB is “in a good place” and well positioned to face future shocks. A fiscal policy change from consolidation to expansion, notably in Germany, has raised expectations that higher infrastructure and defense spending could at last help pull the eurozone economy out of the doldrums. And current market pricing implies that the ECB policy rate will rise above 2% in three years’ time as the economy strengthens.
We envisage a trickier scenario. Despite fiscal policy loosening in Germany, we don’t see strong evidence to support a higher neutral interest rate in the eurozone. Rather, we’re wary of the forces that could push inflation below target, resulting in at least one more rate cut.
Although the ECB’s current reaction function sets a high bar for another cut, we think the medium-term risks of landing under the 2% inflation target are piling up. For now, the ECB is overlooking small, temporary deviations from the target, but if they become larger and more lasting, the Governing Council will have to respond in line with its monetary policy strategy.
Faltering Confidence Belies Near-Term Economic Turnround
We see an improved longer-term outlook for the eurozone economy: the worst-case US tariff outcome has been avoided, and fiscal stimulus is on the way. But shorter-term risks remain. For one thing, the full effects of the new tariffs have yet to be felt. Also, weak confidence indicators (Display, below) and domestic problems in some countries (notably France’s long-running political stalemate) will likely continue to restrain private consumption and investment.