The European Central Bank kept interest rates unchanged for the second consecutive meeting. The decision was in line with market expectations which fully priced in a hold ahead of the decision. Despite the flurry of economic data and the trade agreement with the US in August, the broad economic picture was largely unchanged from the July meeting, strengthening the case to keep rates on hold.However, we see an outsized chance of one more cut this year, with the key deposit rate potentially falling to 1.75% by the end of 2025.
The ECB are in a comfortable position with rates at neutral
The run up to the September meeting was marked by numerous data releases and the announcement of a trade agreement with the US in August. Inflation edged up but remained close to target in August, coming in at 2.1%, slightly up from 2% in July. Despite headline inflation slightly overshooting the June projections, policymakers are likely to be more encouraged by the continued easing of underlying price pressures, with services inflation falling to its lowest level since March 2022. Disinflationary momentum is set to continue over the coming months, as wage growth, a key driver underlying price pressures, continues to moderate. This was reflected in the latest projections which see inflation undershooting its target in both 2026 and 2027.
GDP growth came in at 0.1% in Q2, though this was below the ECB’s June projection of 0.2%. However, this was more than offset by the large upward revision to Q1 GDP, which grew by 0.6%. The strong H1 growth can be attributed partly to the front loading of economic activity by businesses ahead of US tariffs taking effect, as was highlighted by President Lagarde. Although the updated ECB projections have seen headline growth revised up for 2025, a slowdown is nevertheless expected in the second half of the year.
The headline figures continued to mask the Eurozone’s regional divergence, with both Spain and Portugal leading the pack, posting solid growth rates of 0.7% and 0.6% respectively in Q2. This contrasts with the 0.1% contraction in German GDP, where the recent fiscal stimulus announcements are expected take time to filter through the economy. French GDP surprised to the upside in Q2, although momentum is likely to reverse sharply on the back of recent political uncertainty. Weakness amongst the largest economies in the Eurozone was likely behind the downgrade to its growth projections for 2026.
The trade agreement with the US also continues to present a downside risk to the growth outlook. The deal sees the tariff rate on EU exports to the US increasing to around 15% on most goods, somewhat higher than the 10% baseline assumed in the ECB’s June projection. With the risk of retaliatory tariffs receding, we expect on balance the net impact of increased trade frictions to be disinflationary. Tentative evidence of trade diversion and dumping from China is also emerging, with an impact on prices in several sectors, including steel, where imports have risen sharply and prices have fallen in recent months. A recent estimate from the Bank of Italy suggests trade dumping could potentially shave off 0.2 percentage points from Eurozone headline inflation in the next two years, raising the risk of inflation undershooting its target.
Governing Council differences could become more apparent over the coming months
President Lagarde’s struck a notably more hawkish tone in the press conference, but contained little in the form of forward guidance, keeping in line with the ECB’s traditional approach of maintaining policy flexibility. The ECB is in a relatively advantageous position when compared to its counterparts at the Federal Reserve and the Bank of England, with the backdrop of muted inflationary pressures and a steady labour market.
Lagarde confirmed the decision to keep rates unchanged in September was unanimous, however, we expect differences amongst Governing Council members to become more pronounced over the coming months. The minutes from the July meeting showed a growing number of Governors were concerned about downside risks to inflation and growth outlook. Bank of Finland Governor, Oli Rehn, stated “We have to be mindful of the downside risks to inflation”, citing cheaper energy, a stronger euro, and contained service inflation as reasons to not rule out further easing. Rehn also stressed the recent trade deal struck with the US was “worse than assumed in our June baseline”, which would be a downside risk for both growth and inflation. Rehn’s view contrasted with prominent hawk and Executive Board Member, Isabel Schnabel, who was of the view global trade friction would on balance be inflationary by disrupting global supply chains.
We expect the data flow over the coming months to strengthen the case of more dovish leaning Governing Council members. Growth is set to slow further in the second half of the year, while a favourable outlook for energy prices coupled with a strengthening euro, could help keep import costs muted. We may see a further downgrade to the inflation projections in the December meeting. The ECB will likely find it difficult to ignore any more undershooting in the medium term without adjusting policy, which could open the door for further easing before the end of the year. We see scope for one additional rate cut at the December meeting, when the ECB next updates its projections, and expect the key deposit rate to fall to 1.75% by the end of 2025.
