On Thursday, the ECB shocked markets with a historic 25 basis point cut. As part of this change, it will lower its deposit facility rate to 2.25%. With this decision, the ECB has cut rates for the third time this year. Until recently, they were pegged at 4% as of mid-2023. This action comes in direct response to the euro area’s persistently low inflation rate, having remained below 3%. That shows increasing worries over the negative impact of trade tensions on economic growth.
Markets had overwhelmingly expected this interest rate cut, pricing in an almost 94% chance of the cut before the announcement. The ECB’s policy statement indicated that the outlook for growth had “deteriorated owing to rising trade tensions,” emphasizing the need for a proactive monetary policy response to support the economy.
The ECB’s inflation target stands at 2%, and with inflation rates inching closer to this goal, the central bank’s decision to lower rates aims to foster economic growth within the euro zone. After the outcome of the meeting, ECB President Christine Lagarde will give a press conference on the decision. She’ll share her thoughts on what the rate cut means and address other pressing economic issues.
The bilateral trade uncertainty is just one of the reasons for the sudden policy shift by the central bank. Much of this uncertainty comes on the heels of tariff-related announcements from the United States. Jens Eisenschmidt, a prominent economist, commented on this dynamic, stating, “Of course the clear catalyst has been here the lower growth expectation coming out of April 2nd’s announcement related to the U.S. tariffs.” In doing so, he noted that in the past, tariffs typically resulted in a depreciation of the euro, thus creating upward inflationary pressure. The unique conditions we find ourselves in have delivered unexpected results that are starting to raise hopes for an imminent rate cut.
The ECB recognized that heightened uncertainty about trade conflicts will probably weaken sentiment among households and firms. The bank’s statement highlighted that “the adverse and volatile market response to the trade tensions is likely to have a tightening impact on financing conditions.”
Even with these headwinds, the most recent data indicate that the euro area economy has been building a newfound resilience to exogenous shocks. The ECB noted that “most measures of underlying inflation suggest that inflation will settle at around the Governing Council’s 2% medium-term target on a sustained basis.” This observation highlights the need to adhere to a principle of symmetry in monetary policy.
The current trade tensions have certainly placed the ECB between a rock and a hard place. What’s most important to financial markets is how the central bank communicates its evolving view of where this “neutral rate” lies. Second, they’re hoping to see the bank encourage a more accommodative monetary policy stance over the next few months. Julien Lafargue, an economic analyst, remarked, “More importantly for markets will be the extent to which the central bank decides to communicate what it perceives to be the ‘neutral rate,’ and whether monetary policy could turn accommodative – i.e., go below the neutral rate – in the next six to 12 months.”