The European Central Bank (ECB) has cut its deposit facility rate by 25 basis points to 2.75%, amid disappointing growth in the region. While inflation is projected at target this year, from a risk management perspective a level of 2.75% means upside shocks to inflation can potentially still be addressed by a slower pace of rate reductions going forward, while the rate cut offers additional protection against downside risks. In short, the ECB retains plenty of room to manoeuvre.
Since December, the ECB is no longer aiming for sufficiently restrictive policy, but rather intends to deliver an “appropriate” policy stance. As a result, discussion about a suitable neutral policy rate configuration has gained traction. ECB models previously placed the median neutral interest rate for the currency area between 2% and 3%, and, while not providing numbers today, ECB President Christine Lagarde made mention of a neutral policy range of 1.75%–2.25% in Davos last week.
Given uncertainty around the neutral policy range and still too high domestic inflation, policy rates are likely to continue their descent in a gradual fashion. Market pricing for a terminal rate of around 2% remains broadly consistent with our estimates for a neutral policy rate. Nevertheless, we see additional downside risks to growth, particularly in light of tariff threats from the new U.S. administration, and scope for lower terminal rates than currently priced in.
In terms of investment implications, as inflation has largely normalized, duration has regained its risk-hedging characteristic. High quality fixed income looks attractive, European duration offers reasonably priced downside mitigation, and we remain overweight. As for the European interest rate curve, we continue to expect the back end of the interest rate curve to underperform shorter- to-medium maturities due to rate cuts and rebuilding term premia. With the ECB’s balance sheet shrinking, investors are likely to demand additional compensation for investing in longer maturities.
The growth outlook remains weak, inflation on track
Growth in the euro area stagnated in the fourth quarter, and surveys suggest a similar picture going forward. Despite a small uptick in January, the preliminary euro area composite PMI index remains close to the 50 threshold, indicating continued economic sluggishness. More broadly, incoming data increasingly raise the question of what might drive the projected economic expansion.
None of the demand components have yet shown the strengthening foreseen in consecutive ECB staff projections. Particular question marks surround consumption-led growth in economic activity in the projections, with the data instead pointing to a substantial increase in the saving rate and a decline in consumer confidence. In addition, firms might continue holding back on investment, which could contract further in the first half of 2025.
