ECB Preview: no-brainer cut expected despite higher inflation

The European Central Bank (ECB) is expected to cut rates again when they meet on Thursday. Markets have no doubt about that, with the odds leaning in favour of a 25 bps cut versus a 50 bps cut at 92% vs 8% respectively. Recent commentary from ECB Governing Council (GC) members, including President Christine Lagarde, reinforces expectations for further monetary easing. Speaking at the World Economic Forum in Davos last week, Lagarde defended the ECB’s rate-cutting trajectory while emphasizing the need for structural economic reforms in Europe.

Balancing Growth and Inflation Risks

Recent data suggests a potential risk of stagflation, with sluggish economic growth coinciding with an uptick in inflation. However, the ECB appears to view this inflationary resurgence as temporary. Even traditionally hawkish GC members have recently sounded more dovish, likely influenced by the central bank’s December projections, which assumed a terminal rate below 2%—implying 100 basis points of cuts from current levels. Additionally, concerns about European growth risks stemming from potential policy shifts under the Trump administration may be shaping the ECB’s cautious outlook.

In the long run, as long as inflation remains on a downward trajectory, the ECB is likely to overlook short-term price increases. Given that interest rates at 3% are still considered restrictive—particularly amid a weakening Eurozone economy—further rate cuts seem inevitable. Current market pricing suggests around 90 basis points of easing by December.

ECB Policy Outlook: Slow but Steady Easing

Rising bond yields have tightened financial conditions in Europe, adding further justification for a rate cut. However, Lagarde is expected to maintain a cautious approach, reiterating her stance from December and Davos: rates will remain in restrictive territory, but gradual easing is on the horizon. While she is unlikely to pre-commit to a specific easing path, the ECB will likely continue cutting rates at a measured pace to balance inflation risks with economic support.

The ECB aims to stay ahead of the curve while avoiding a scenario where rates fall too low too quickly. This measured approach will likely prevent an ultra-loose monetary policy but should see the bank return rates to neutral levels as swiftly as conditions allow.

Market Impact: Equities Benefit, Euro Struggles

The ECB’s dovish stance has provided a tailwind for European equities, with the STOXX 600 and DAX 40 emerging as clear outperformers in recent weeks. As momentum shifts from U.S. to European markets, further upside in European stocks remains a strong possibility.

In contrast, the euro continues to struggle against the U.S. dollar. EUR/USD has repeatedly failed to consolidate above 1.05, and the upcoming ECB meeting is unlikely to provide meaningful support for the currency. While the dollar has faced some selling pressure due to a fading “U.S. exceptionalism” narrative, structural weaknesses within the Eurozone economy are likely to keep the euro under pressure, limiting its ability to attract strong buying interest.

EUR/USD daily chart

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