Eurozone economy in focus as ECB eyes sixth consecutive rate cut

The European Central Bank (ECB) is widely expected to cut interest rates again, continuing its efforts to support a fragile eurozone economy weighed down by a combination of sluggish growth, stubborn inflation, and external threats – many of which lie beyond its control.

This week’s expected rate cut will bring the ECB’s key deposit rate down to 2.5 per cent, marking the sixth cut in the current easing cycle. After years of raising rates to tame inflation, the ECB has been gradually shifting its stance since June 2024 as the economic outlook deteriorated. Analysts now expect the deposit rate to fall to two per cent by the end of the year.

The ECB’s decision comes at a time when global trade tensions, largely driven by US President Donald Trump’s tariff agenda, are creating new economic uncertainties. Mr Trump has vowed to impose 25 per cent tariffs on European imports, raising fears of a damaging trade war that could further weaken already fragile economic growth across the eurozone.

In addition to targeting Europe, Mr Trump has also imposed 25 per cent tariffs on imports from Canada and Mexico, and increased levies on Chinese goods to 20 per cent. These escalating trade measures risk disrupting supply chains, creating production bottlenecks, and, crucially, undermining business and consumer confidence. Analysts at Barclays warned that a full-scale trade war between the US and the EU could shave up to 0.4 per cent off eurozone GDP within the first year.

Europe’s two largest economies, Germany and France, both contracted in the final quarter of 2024, with Germany suffering its second consecutive year of economic shrinkage. Germany’s manufacturing sector, already weakened by high energy costs triggered by the Russia-Ukraine war, would be particularly vulnerable to US tariffs, especially in automotive exports.

Inflation outlook key to ECB’s path

While external factors dominate the headlines, the ECB’s primary focus remains inflation. The latest flash Consumer Price Index (CPI) for March will be a critical data point shaping the Governing Council’s outlook.

In January, headline inflation rose for a fourth consecutive month to 2.5 per cent, partly driven by increased energy demand due to cold weather. However, ECB President Christine Lagarde has expressed confidence that inflation is gradually returning to the central bank’s two per cent target over the medium term. Provisional data for February is expected to show inflation easing to 2.3 per cent, with core inflation, which strips out volatile food and energy prices, forecast to dip to 2.6 per cent from 2.7 per cent the previous month.

This softening inflation backdrop, combined with sluggish growth and rising unemployment, strengthens the case for continued monetary easing. Several senior ECB policymakers, including Bank of France Governor François Villeroy de Galhau and Greece’s Yannis Stournaras, have publicly backed further rate cuts this year.

How low should rates go?

Despite broad agreement within the Governing Council that policy should no longer restrain growth, there is emerging debate about just how much stimulus is required. The ECB considers a two per cent deposit rate to be broadly “neutral” – neither restrictive nor stimulative.

However, some Governing Council members, including Isabel Schnabel, argue that the natural rate of interest may have risen in recent years due to global economic shifts, meaning monetary policy might already be less restrictive than assumed. This view has been echoed by Joachim Nagel and Pierre Wunsch, who have expressed caution about over-signalling further cuts.

That said, many economists believe structural weaknesses in the eurozone economy, coupled with Mr Trump’s tariff threats and softening inflation, will ultimately force the ECB to lower rates to two per cent or even below this year. As Carsten Brzeski, global head of macro at ING, put it: “The structural weakness of the eurozone economy, as well as looming tariffs and lower inflationary pressure on the back of a turning labour market, will force the ECB to bring rates down to at least two per cent, even if not all ECB members might like it.”

Mr Trump’s tariff threats have bolstered the dollar on expectations of higher US inflation, while the ECB’s increasingly dovish stance relative to the US Federal Reserve has further weighed on the single currency. Some analysts believe euro-dollar parity could be reached later this year if trade tensions escalate.

Despite these economic and political challenges, European stock markets have outperformed their US peers so far this year. The Euro Stoxx 600 index is up nearly 10 per cent, while Germany’s DAX has gained 13 per cent. In contrast, the S&P 500 has risen just 1.5 per cent. The expectation of lower interest rates has been a key driver of this rally, along with a surge in European defence stocks following Trump’s calls for higher European military spending amid peace talks with Russia.