Dispatch€s from Frankfurt: ECB: Mission Accomplished
Keeping inflation on target will likely require one more cut
I came away with the impression that today was a communications victory of sorts for the hawkish camp. That may be sufficient to signal a pause for July. However, my central case on tariffs and the economy is somewhat less sanguine than the ECB staff baseline. While ECB rates are now “in a good place” to respond to changes in the outlook, respond they will in my view: I still think there should be one more cut. I thus maintain my baseline for a 1.75% terminus in September.
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Mission accomplished. Headline (core) inflation forecasts for 2025-27 are at 2.0% (2.4%), 1.6% (1.9%), and 2.0% (1.9%) in the new staff baseline. Essentially, inflation has returned to target, allowing the governing council to – for all intents and purposes – declare victory today.
“In a good place”: non-committal means pause in July. The degree of alertness and willingness to respond to contingencies the council signalled in the April meeting was notably dialled down today. Instead, there was a considerable degree of confidence about the euro area’s “resilience in the face of global shocks” (more on this, shortly).
Thus, Christine Lagarde was non-committal about any further steps on rates, despite the best efforts of journalists to elicit whether the ECB is done cutting.
I would see today’s performance as suggesting there is a pause to come in July.
However, this does not mean rates have arrived at their terminus.
Indeed, the ECB President saying that rates are “in a good place” to respond to the contingencies ahead does mean that the ECB remains very much ready to pull the trigger. In theory, that would be in either direction, but the outlook does not suggest that a cut and a hike are equally likely.
So, is this it? There are a number of reasons why I don’t think the ECB has arrived at a truly unbiased stance – and hence why I still think the terminal rate will be 1.75% in the end.
First, the sag of headline inflation next year (to 1.6% annual average) in the baseline projection should per se be sufficient to impart a downward bias to the current level of rates:
while Christine Lagarde’s communications choice was to stress the return to 2% in the terminal forecast year (2027), this is something of a departure with established practice whereby the ECB has in the past de-emphasised the inflation terminus.
the euro could well be poised to strengthen further if the mood music among international investors with respect to investing in US assets is anything to go by.
energy prices should at least to some extent transmit into wage settlements going forward and hence all else equal temper underlying pressures too – although that may already be captured to some extent by the ECB numbers via the conventional elasticities staff use.
Second, the forecast baseline on tariffs is essentially benign. It assumes that US tariffs will increase to 10% vis-à-vis everyone but China – hence including the EU – and there is no EU retaliation. This looks like the best possible scenario, since the 10% seems to be established as the “bedrock” tariff by the Trump administration.
Third, ECB communication emphasized “resilience to global shocks”. My feeling would be that this resilience is a bit optimistic in case things do get worse on the trade front as there are fewer buffers – for example, profit margins have been declining, and firms have been hoarding labor for a while now.
What’s more, my impression is that the communication, if not necessarily the staff numbers, is being somewhat guilty of “temporal aggregation”.
A big deal is made of the infrastructure and defense impact over the medium term, but the sense one gets is that this is juxtaposed with the potential effects of tariffs. However, the former should be backloaded, while the latter are likely to be frontloaded.
Overall, the communication today was more hawkish than I anticipated. Perhaps the hawkish camp put up more resistance in order to avoid the ECB painting itself into a corner with dovish language that would force it to deliver another cut. However, I do think that one more cut will be needed, and stick to my baseline for a 1.75% terminus for September, when the next batch of projections arrives.