The European Central Bank (ECB) is immersed in a cycle of rate cuts in a situation that few would have expected just a year ago. Inflation is falling faster than expected and the threats on the horizon for the euro zone economy do not stop growing. In a simple way: falling inflation and economic stagnation can only have one response from the ECB, which is lower rates as much as necessary. According to a report recently published by Deutsche Bank, right now the ‘terminal rate’ (the last of the reduction cycle) of the ECB will be between 1% and 1.75%a much lower range than the previous forecast of 2.25%. “We are reducing our central forecast for the terminal rate from 2.25% to 1.50%,” although the floor could be even lower. The German bank’s analysts thus join other strategists who have been telegraphing a terminal rate below 2% for weeks, as did Mathieu Savary, chief strategist at BCA Research, in statements to elEconomista.es.
Deutsche Bank economists identify four key factors that will influence the path of the ECB’s monetary policy: fiscal policy, the economic situation in Germany, developments in China, oil prices and future US tariffs. In this context, they highlight that “The global economy could be entering a different regime, with macroeconomic conditions in Europe increasingly divergent from those in the United States.”
The decision to reduce the terminal interest rate also responds, in part, to the impact of possible tariffs imposed by the new Trump administration in the US. “The prospect of higher US tariffs threatens a new terms of trade shock,” warn economists, who also highlight that these tariffs could trigger an increase in economic uncertainty, similar to the situation experienced in 2018-2019 during Trump’s first term. The euro zone is a net exporter and a good part of its citizens’ income comes from a high current account surplus. Tariffs threaten to reduce this surplus and hamper the growth of the European continent.
The US is the main trading partner (in terms of added value) of the EU, with 15% of exports, and of the United Kingdomwith 18% (although the EU as a whole is higher). Thus, any attempt by the new US administration to impose universal trade tariffs could have a significant and direct impact on demand for European exports.
“Its scope is difficult to gauge, as it is still unknown whether President-elect Trump will impose tariffs on European exports and, if so, at what level after what are likely to be long and difficult negotiations that could lead to measures of short-term retaliation. But a possible loss of consumer and business confidence if trade tariffs remain in place could have an even greater impact on the economy,” UBS analysts Dean Turner and Matthew Gilman warn in a note in which They also defend that the Eurobank will cut more than they had planned. ECB President Christine Lagarde herself explicitly highlighted Trump as a risk to growth during the press conference at the central bank’s latest meeting.
Although the European economy has shown signs of resilience, with positive GDP growth in the first three quarters of 2024, underlying macroeconomic data is weak, and projected growth for the coming years has been revised downwards. “We expect Eurozone GDP growth to be 0.7% in 2024 and 1% in 2025, figures below previous expectations,” they point out from Deutsche Bank. This is due, in part, to a slowdown in the German economy, which faces structural competitiveness challenges and a reduction in confidence. Weakening household demand and declining business investment in the near term also threatens UBS economists’ 1% growth estimate downwards.
The old problems of inflation return
The report also highlights concerns about inflation… not because it will be very high, but quite the opposite. According to Deutsche Bank calculations, general inflation in the euro zone could fall below the 2% target towards the beginning of 2025, six months ahead of the BC forecastsE. However, analysts emphasize that “we are not overly concerned about a significant and persistent deviation in inflation,” as several core inflation indicators remain stable around the 2% target. The sharp drop in the price of oil since the summer until now is causing general prices to lose intensity much more strongly than expected.
The uncertainty surrounding US tariffs also extends to their possible impact on inflation. “We calculate that universal tariffs of 10% could have little net impact on European inflation, because the blow to growth is disinflationary, but it could be offset by the pressure of the tariffs themselves and a weakness of the euro,” they explain.
The real source of uncertainty about inflation is the indirect effects of the 50-60% tariffs on China and whether and to what extent this triggers dumping of exports to Europe. “This could further affect European growth by expelling European production and subtracting up to half a point from the euro zone CPI, according to a recent analysis by the ECB,” they say from Deutsche Bank. “A policy response from China that translates into a boost in production and supply of goods to economies outside the US could aggravate disinflationary pressure in Europe,” corroborate Turner and Gilman from UBS.
“The economy is unlikely to improve as a wait-and-see attitude could prevail among export-oriented companies. The 10% tariff on European products is probably manageable, but the 60% tariff on Chinese products may be very disruptive, either by reducing Chinese demand, or by triggering a massive devaluation of the yuan, and/or incentivizing Chinese producers to compete more fiercely with European suppliers outside the US market,” points in the same direction, Gilles Moëc, chief economist at AXAin a comment advocating an acceleration of ECB rate cuts.
Spending cuts are coming… in principle
On the fiscal front, Deutsche Bank economists point out that austerity policies in countries like France could negatively impact the recovery, while other economies. The necessary fiscal adjustment in some countries may weigh on the euro zone economy as a whole. “The greater amount of public savings together with a high level of private savings could hinder the economic recovery,” they say.
The situation in Germany, as Europe’s largest economy, remains crucial for the euro zone. “Germany is experiencing a confidence shock, possibly reflecting structurally weak competitiveness,” the report notes. The German economy could face a further decline in investment and employment, which would be a drag on economic growth across the region.
“We’ve seen quite a bit of contagion from US long-term yields onto European ones recently, and this won’t help Europe’s fiscal equation. This is another reason why the ECB will have to ‘compensate’ with faster cuts. Fortunately, “It seems that even the hawks are changing their tune at the ECB,” says Moëc from AXA.
The analyst believes that European national governments are not in an ideal position to provide reassurance or guidance, as both France and Germany are in the midst of internal political difficulties, while EU populists will want to push their advantage. “The ECB is the only European institution with the capacity to respond quickly in the current configuration,” he emphasizes.
The forecast for The ECB’s terminal rate, which Deutsche Bank, now stands between 1% and 1.75%reflects this entire context. German analysts emphasize that “it is essential to emphasize the high degree of uncertainty around the path of growth, inflation and monetary policy in the future.” According to the report, this downward revision of the terminal rate suggests that the ECB could lead to larger interest rate cuts in its next meetings to close the gap between current rates, which are considered restrictive, and the desired level. more neutral or even slightly expansive.
At this point, Deutsche Bank warns that the ECB could decide to implement cuts of up to 50 basis points instead of the expected 25 points, depending on the data that arrives in the coming weeks. Hypotheses that other prominent analysts buy. “We agree that the prospects for US protectionism in 2025 make it more likely that the ECB will cut rates by 50 basis points in December this year. And we see a terminal rate of 1.75% in 2025 – perhaps as early as the second quarter next year – as European policymakers take rates into slightly accommodative territory,” say those at ING. Its economist Michiel Tukker is clear that, with the ECB’s reaction function shifting more towards growth concerns, the chances of a 50 basis point cut later are more likely now.
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