The European Central Bank will almost certainly cut rates by 25bp today, its sixth cut in a row, and an outcome that is fully priced in though a volatile economic backdrop is sowing divisions over where to take borrowing costs from here. With the deposit rate being lowered to 2.5%, the question – as ING Economics writes – is whether ECB President Christine Lagarde will still characterize policy as “restrictive”. ING thinks she will, but failing to do so could trigger further hawkish repricing for a currency that has already soared 300 pips in the past 48 hours, breaking out of a key range.
Indeed, while today’s 25bps rate cut is fully priced in, the outlook for next month is already becoming a lot less certain: a cut in April is seen with only a 60% probability. The market is homing in on a quarterly cutting schedule after this week. It is also still eyeing the possibility of the ECB cutting rates below 2% eventually, with the forward OIS for the year end below 1.9%. US tariffs could yet become more concrete and weigh on the macro outlook. But the perceived chances of the ECB cutting faster and further have slimmed noticeably again after the latest flash inflation readings declined less than markets had hoped.
Given the ECB’s recent tendency to give little away in terms of forward guidance, ING thinks the determinant for market reaction will be whether President Lagarde continues to characterise monetary policy as “restrictive”. This is particularly relevant as a 25bp cut would take the deposit rate to 2.5%, which is the upper-bound of the neutral rate range. As shown in our scenario analysis above, we think the “restrictive” reference will remain in place for now, which could be received by the market as a moderately dovish signal.
Meanwhile, analysts polled by Bloomberg almost unanimously predict a quarter-point decrease in the deposit rate, to 2.5%, on Thursday. Beyond that, opinions vary greatly: One sees no more reductions while others reckon the benchmark will go all the way to 1% in early 2026.
Such stark differences reflect fraying unity among officials themselves. While there’s been little major disagreement over the monetary loosening to date, views are diverging on whether inflation is in more danger of over- or undershooting, and how much support should be offered to the region’s misfiring economy.
Muddying the waters further are the implications of the US’s sudden decision to pull back military support for Ukraine and Europe, sparking a rush to rearm that will bring hundreds of billions of euros in spending across the region in the years ahead. European leaders are set to further discuss the issue at a summit Thursday in Brussels, with markets now favoring just two more ECB rate cuts this year.
Lingering questions on EU defense spending impact
The ECB Council remains constrained by sticky core inflation readings. While it’s forecasting the data to eventually fall in line with targets, this uncertainty around inflation limits the Council’s ability to sound more dovish as policy rates close in on the neutral rate. It will only add to any ECB caution that larger stimulus is now being discussed by eurozone countries and importantly in Germany, and not just for defence spending. The numbers involved look huge with €900bn across two special funds, one for defence and one for infrastructure investments. But so far, there is very little known about the crucial details, such as the time frame or whether these numbers reflect the final outcome.
Markets would not be surprised if the ECB were questioned about its stance on the implications of defense spending for longer term bond markets, and potentially the impact on those countries with already constrained finances. We suspect that as long as eurozone government bond spreads remain relatively stable, the ECB will be content with a standard pointer to the Transmission Protection Mechanism (TPI). One question to ask would be whether the EU plans to trigger national escape clauses from the deficit rules, which would also impact the conditionality of the backstop.
Going back to the market, Bloomberg notes that traders price 62 basis points of easing — including a quarter point reduction today — down from 65 basis points on Wednesday and 85 basis points last week
“The decision this Thursday should be straightforward, but the discussions within the Governing Council are undoubtedly going to become more heated,” said Sonja Marten, head of research currencies and monetary policy at DZ Bank. “This may be the last ‘clear-cut’ decision from the ECB this year.”
While policymakers including Executive Board member Isabel Schnabel have urged the ECB to begin discussing a pause in rate cuts, or halting them altogether, no one appears to object strongly to this week’s move. Should it transpire, easing since June would reach 150 basis points, twice what the Bank of England has so far managed during its cutting cycle and also more than the Federal Reserve’s 100 basis points.
Discord at the ECB is intensifying in part over how much monetary policy is restraining the economy. Schnabel is “no longer sure whether it is still restrictive.” Greece’s Yannis Stournaras thinks “we are definitely still in restrictive territory.”
Officials concur that rates should be brought to levels that no longer constrain activity, known as neutral. Only a few, though, have floated the idea of pushing even lower to stimulate demand. While a recent study by ECB staff put neutral at 1.75% to 2.25%, some hawks say it may be higher.
Communication
Analysts and investors will focus on whether the ECB continues to describe policy as “restrictive.” Removing that wording from this month’s statement was already seen as an option after January’s meeting. Sticking to this language would signal rates will be reduced further — the next time probably coming in April. Omitting it would set the stage for a pause, maybe as soon as next month, but could also be interpreted by some as an end to cuts.
Perhaps the likeliest outcome is a compromise. That would see the language modified without being removed entirely, as the ECB and Lagarde are expected to steer clear of giving firm guidance given the unpredictable global picture. “Macro indicators can quickly become outdated with the currently very fast-paced and sometimes erratic political environment,“ said Carsten Brzeski, head of macro research at ING. “The ECB’s best approach therefore is to run on sight.”
Geopolitics
Complicating the ECB’s task is the rapidly shifting geopolitical environment. President Donald Trump’s escalating trade war and the knock-on effects of his decision to recalibrate US security alliances are the main challenges for policymakers.
While tariffs are generally seen as negative for Europe’s economic outlook, the implications for inflation are less clear. There may be growth benefits from the continent ramping up defense spending and from Chancellor-in-waiting Friedrich Merz pushing for huge infrastructure outlays in Germany.
EU leaders are meeting Thursday in Brussels to discuss more military aid for Ukraine, as well as plans to bolster the capabilities of their own armed forces. Greece’s Stournaras said last week that “if there’s going to be a common objective of the EU to boost defense spending, we can discuss what the ECB can do to support that goal.”
Economists at Allianz warned that if heftier budget deficits threaten debt sustainability and trigger widening government bond spreads, the ECB may have to restart large-scale bond purchases through its Transmission Protection Instrument.
Forecasts
Analysts expect only marginal changes to quarterly projections for economic growth and inflation — supporting the ECB’s overall assessment that consumer-price growth is on track to hit 2% and conditions for a euro-area recovery are in place.
Average inflation for 2025, though, could be revised up from December’s 2.1% forecast — mainly due to higher energy costs.
Morgan Stanley’s Jens Eisenschmidt, a former ECB economist, expects the updated outlook to show price growth only returning to target in the first three months of 2026, instead of this year as envisaged before. While coming in just above analyst expectations, inflation cooled to 2.4% in February from 2.5% the previous month, with the closely watched services gauge sinking to 3.7%.
Source: ING Economics, Bloomberg
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