L’AGEFI – High hurdle for the ECB to exit neutral

Translation of an article published by L’AGEFI on 30 May 2025
By Michala MARCUSSEN, Group Chief Economist

Inflation in France clocked in at just 0.6% YoY in May on the harmonised index, marking the weakest level since December 2020 and sharply down from the peak of just over 7% in early 2023. This easing of inflation was broad-based, although energy prices contributed significantly in May. Similar trends are observed across the euro area, and headline inflation for the region is now close to the ECB’s 2% target. The consensus of economists is, moreover, for inflation to remain at these levels over the coming years, aided not just by low energy prices, but also by a firm euro and easing wage dynamics.

This backdrop has allowed the ECB to ease the deposit rate to a level consistent with the neutral range, seen at 1.75-2.25%. With tariffs and broader uncertainty on the future direction of US policy adding downside risk to an already lacklustre growth outlook, question next is whether the ECB should take out insurance against those downside risks to growth, with further substantial rate cuts, or just hold steady at neutral.

The answer depends on two elements; first, the expected inflationary impact stemming from the risk factors, and second, the perceived trade-offs in setting monetary policy.

Tariffs are first and foremost inflationary in the country imposing them, but in adding new frictions to global supply chains, global inflationary spillover effects may arise. Retaliatory tariffs add further upside to inflation to the countries imposing them. As higher tariffs erode real economic activity, such inflationary impacts are likely to prove transitory as the disinflationary pull from weaker economic activity and rising unemployment feed through and act as a counterbalance.

Already now, weaker global growth prospects explain part of the recent decline in energy prices, although higher OPEC+ production quotas also factor in. A further disinflationary channel from tariffs comes from the redirecting by exporters to other markets to avoid tariffs. In Europe, there is clearly a concern that cheaper goods, not least from Asia, could grab market share and undercut pricing power of European companies.

In a surprise twist, the US dollar has substantially depreciated since March, countering expectations that higher US tariffs would drive dollar appreciation. This may be explained by several factors, ranging from investors’ downward reassessment of the US growth outlook to concerns about the future tax treatment of foreign investors in the US, or broader concerns about the sustainability of US public finances, as witnessed also by the substantial increase in estimated term premia on long-dated US Treasury bonds.

Expectations

An important guide for the ECB in this uncertain environment is inflation expectations. In financial markets, these remain well anchored. And while the ECB’s Access to Finance Survey points to some concerns on production costs, expectations for selling prices have been holding fairly stable in recent month’s surveys at close to 3%. Turning to the ECB’s consumer expectations, however, the latest survey from April showed yet an uptick in the twelve-month median inflation outlook to 3.1% from 2.6% back in January.

As highlighted by ECB Board Member Isabel Schnabel in her 10 May speech, when inflation expectations have a low sensitivity to realised inflation, then policymakers can more readily tolerate moderate deviations of actual inflation from target, and this in both directions. Having just come out of a high inflation episode, inflation expectations may arguably have become more sensitive to any new upside inflation surprises. Press headlines warning of higher inflation from US tariffs may well have been a factor shaping recent consumer expectations, and this despite easing headline inflation in the euro area. Last time, with the shock from the pandemic, the ECB will have in mind that consumers did a generally better job than financial markets in capturing future inflation trends.

The ECB is thus left with an important challenge in considering if and when to leave the neutral range of interest rates. A further neutrality consideration resides on the ECB balance sheet, with the question of when to halt the ongoing process of passive quantitative tightening (QT). Here too surveys play a role, with the ECB’s bank lending survey reporting only a small negative impact from QT in April. Should upcoming surveys point to a more adverse negative impact, then this will be a strong signal that neutrality may also be close on the balance sheet, encouraging the ECB to stop QT.

Given the numerous uncertainties, neutral may prove a very comfortable place for the ECB and it seems likely that given the many uncertainties, both on the inflation outlook and the trade-off faced by monetary policy, that the hurdle to exit neutral will be high.