The market broadly expects the ECB to cut rates again on Thursday, with traders hoping to gauge how far the central bank is willing to diverge from the stalled Federal Reserve at its first policy meeting this year.
On Wednesday, pricing in the money markets showed that traders expect the ECB to cut rates by 35 basis points at its January meeting, indicating at least a 25 basis point cut, bringing the key rate to 2.75%. This would be the fifth rate cut by the ECB since it began easing monetary policy in June 2024.
Market pricing also indicates that the ECB will further cut rates at its meetings in March and June, with this year's fourth and final cut bringing the deposit rate to 2% by the end of the year.
Despite the eurozone's overall inflation rising for the third consecutive month last December, market expectations for a rapid easing by the European Central Bank this year have solidified. Due to the impact of energy markets, the rate of price increases in the eurozone is expected to rise slightly. Meanwhile, the EU's business activity indicators show continued weakness in manufacturing and lukewarm consumer confidence. Economists surveyed by Reuters expect the eurozone's GDP growth in the fourth quarter of last year to be only 0.1%, down from 0.4% in the third quarter.
This week's rate cut by the ECB is almost a given, but President Lagarde may be asked several key questions at the subsequent press conference—many of which relate to the US and its new leadership.
A concerning question is whether the European Central Bank is willing to accept the widening gap between its monetary policy path and that of the world's largest central bank, the Federal Reserve. The Fed is expected to maintain interest rates at its meeting on Wednesday. The market anticipates that the Fed will only cut rates twice this year, by just 25 basis points, as predicted by Fed members last December.
Some strategists believe that the Federal Reserve may only implement one rate cut this year. At least while awaiting more details on Trump's actual policies, as well as his extreme trade threats and their potential inflation impacts, the Fed will take a wait-and-see approach.
Lagarde acknowledged this divergence during an interview at the World Economic Forum last week, telling CNBC that it is a result of different economic environments. While economic growth in the eurozone is stagnating, the US economy continues to grow robustly in a high-interest-rate environment, and despite uncertainties surrounding Trump, many investors hold an optimistic view of the outlook for 2025.
Investec economist Sandra Horsfield stated on Wednesday, 'This divergence does indeed suggest that inflationary pressures in the US are more likely to persist for some time,' leading her to predict that the Fed will cut rates again before pausing, while the cuts in the eurozone will be larger.
Currency depreciation
The European Central Bank has repeatedly emphasized its willingness to act ahead of the Fed and focus on domestic inflation and growth conditions. However, the main impact of policy differences is on foreign exchange, as higher interest rates tend to boost the domestic currency.
This reinforces expectations that the euro may fall back to parity with the dollar, leading the already strong dollar to strengthen further by 2025. Maintaining stable exchange rates is important for the European Central Bank as a weak currency increases the cost of imported goods, even though the ECB's greater concern now is related to rising domestic services and wages.
Lagarde downplayed this impact, telling CNBC that exchange rates 'will attract attention, and... there may be consequences.'
However, she also said she is not worried about imported inflation and continues to expect inflation to cool to target levels. The ECB president added that the optimism surrounding the US economy is positive, 'because US economic growth has always been a favorable factor for the rest of the world.'
The so-called risk reversal indicator (a barometer of market sentiment) shows that the cost of hedging against a weakening euro by the end of the year is near its highest level since June. According to data from the Depository Trust & Clearing Corporation, demand for options betting that the euro will at least fall to parity with the dollar has more than doubled this month compared to November and December.
Trade issues
The weakness of the euro may be a factor prompting the European Central Bank to exercise caution in its rate cuts, but Trump could also trigger a trade war focused on the globe, and even Europe, further slowing growth in the eurozone and creating a need for additional rate cuts.
Trump has not reintroduced his idea of imposing comprehensive and universal tariffs on US imports and is currently focused on tariffs against China, Mexico, and Canada. However, in a speech at the World Economic Forum, he accused the EU of treating the US 'very unfairly' in trade and promised, 'We will do something about it.'
George Lagarias, chief economist at Forvis Mazars, stated that trade wars could disrupt global supply chains and exacerbate inflation, giving the European Central Bank reason to raise interest rates. He told CNBC that inflation and interest rate risks in the eurozone are definitely biased upward.
"The sales price expectations of EU companies have flattened out and show an upward trend. This is a leading indicator of the ECB's own forecasts... The Fed may take a more hawkish path, so there may be a risk of capital flight to the US due to significant divergences from the ECB," he added.
Regarding the possibility of a larger 50 basis point rate cut by the ECB, he said, 'If the ECB really cuts rates significantly, it would mean the board is seeking to protect the economic growth of core eurozone countries and ensure that political uncertainties in France and Germany or Italy's loose fiscal policies do not lead to a sharp rise in borrowing rates.'
Bas van Geffen, senior macro strategist at RaboResearch, stated that he 'is not as optimistic about the inflation outlook as the ECB or the market seems to be,' predicting that interest rates will fall to 2.25% this year.
"When the ECB incorporates Trump's tariff policies into its baseline scenario, we expect they will also make higher inflation forecasts," he told CNBC.
Article reposted from: Jinshi Data