ECB Preview - Shocks to make neutral rate debate a moot point
With the ECB having cut its key deposit rate by 125bp and another 25bp to follow at the March meeting, a debate has been raging about where the end point of the rate cut cycle would be. Indeed, a reduction at next week’s meeting, would leave the policy rate at 2.5%, which is at the upper bound of the nominal range of the most up to date neutral rate estimates (1.5-2.5%*).
Some of the more hawkish Governing Council members, most notably Isabel Schnabel, have been making the case of why the neutral rate may be higher. Ms Schnable points to the shift from a ‘savings glut to a bond glut’ and higher climate investments as arguments. More dovish officials, such as Piero Cipollone have suggested QT is actually a reason for deeper rate cuts as it tightens financial conditions. Meanwhile, some of the lower end estimates of neutral rates incorporate that the structural outlook for the eurozone is weak. Many of the centrists on the Governing Council seems to be comfortable with an eventual end to rate cuts at around 2%.
This debate will most likely become a moot point. It would be something of a minor miracle if, in a world of such geopolitical and economic uncertainty, the economy, inflation and therefore interest rates would all just calmly return to equilibrium levels. Indeed, in reality, significant upcoming shocks are likely to take us to areas that are far from ‘normal’. At the same time, neutral interest rates are unobservable in any case. ECB Chief Economist Philip Lane has poured cold water on the concept of neutral driving interest rate decisions, saying that the policy rate decisions will be driven at each point by where the central bank judges inflation to be heading in the medium term.
Over the coming weeks the shocks – and potentially large shocks – facing the eurozone economy will become clearer. The new US administration’ s tariff policies look like being even more aggressive than we are currently assuming (see our note ), even though we have been on the gloomy end of the consensus. The ECB has been clear that tariffs will worsen the outlook for economic growth in the eurozone, though it judges that the impact on inflation is ambiguous. Meanwhile, there are signs that we could see more government spending in the eurozone, especially on defence (see our note ). The ECB’s current projections do not take any of these developments into account, while the March update is likely to include only some portion of tariff announcements if any. So one way or the other, the outlook could significantly change in the coming months.
Our base case is that interest rates will be cut deeper than financial markets are currently pricing in, largely because our view of these upcoming shocks. While tariffs will be clearly inflationary for the US economy, we think that they will prove to be disinflationary for the eurozone. The direct upward impact on tariffs on eurozone inflation will likely be limited (even if the EU were to retaliate strongly) while the indirect effects via lower domestic and global growth will likely overwhelm these. In terms of any direct impact of tariffs on eurozone inflation, we note that the US share of eurozone goods imports stands at just 13%; around 20-30% of goods consumption is imported; and goods makes up 26% of the HICP basket. Based on this, even a 10% rise in the price of US goods imports would add only 0.1pp to HICP inflation.
When it comes to fiscal policy, it is too early to have much of a picture of the magnitude of extra spending. However, the nature of defence expenditure means it might be spread out, while the growth effects would be offset if a lot of the defence equipment is imported. So we continue to put more weight on the tariffs as a shock that will lower growth and inflation in the eurozone. We expect the ECB to eventually cut its deposit rate down to 1%.
Given the uncertainty about the timing and nature of the shocks, we could see a temporary pause in the rate cut cycle at some point, or at least a slowdown in rate cuts until there is more clarity. Currently in our base case, we have pencilled in a short pause in the rate cut cycle at the April Governing Council meeting (followed by subsequent rate cuts from June) but we don’t have much conviction on the timing of this. It depends on when there is more clarity on the outlook. We have much more conviction on the view that interest rates will eventually be cut more significantly than generally expected.