ECB Preview - Tariffs could trigger deeper ECB rate cuts

The central view of the Governing Council is that inflation will sustainably reach 2% from the first half of this year onwards, that the economy is recovering but lacklustre and monetary policy is still in restrictive territory. Against this background, there is very strong agreement that the policy rate needs to be brought back to a neutral level. The neutral level is of course a subject of debate, but around 2% seems to be something that most officials would sign up to. Various GC members have said that we should reach those kinds of levels by (around) the summer, and almost all judge that a 25bp step pace is appropriate.

Although the ECB is data-dependent and follows a meeting-by-meeting approach, economic reports and developments would really need to cast serious doubt on the central bank’s views on the outlook for inflation for it to abort this gradual normalisation trajectory. The bar seems to be rather high for an adjustment at this stage.

As for what happens beyond that, a lot depends on the tariff policies of the new US administration and how they impact trade and inflation. At this moment in time, no ECB official has made the case for an accommodative policy stance, and most appear to be taking a wait-and-see approach, which is logical. However, one hint towards a more dovish stance potentially, is how views are developing about the economic effects of tariffs. While, there is general agreement that tariffs will be bad for economic growth, there has been less clear conviction about the impact on inflation.

However, the ECB’s thinking on inflation seems to be shifting. Banque de France Governor Villeroy said at Davos that US tariffs might be inflationary for the US but should have little effect on eurozone inflation. Meanwhile, President Lagarde noted – also at Davos – that she was not ‘overly concerned’ about the US exporting inflation to Europe. So, if we do get tariffs, the ECB might view this as mainly being a negative for growth. Our own thinking goes further on this point. We think US tariffs would have a disinflationary impact on the eurozone, even in the case that the EU would retaliate. This is because the direct upward impact on inflation would be modest, while the indirect downward impact on inflation, via lower global trade and commodity prices, would likely be significant. This is an important factor behind our view that the ECB policy rate will eventually be reduced to 1%.