ECB chief economist declares rate cycle finished as inflation falls below target

The European Central Bank has effectively closed the chapter on the most aggressive monetary tightening in its history. Philip Lane, the institution's chief economist, used the ECB's annual forum in Sintra, Portugal, to declare that the rate cycle designed to drag inflation down from its 10% peak is finished. The confirmation came as Eurostat's flash estimate showed eurozone annual inflation at 1.9% in May, the first reading below the 2% target since the energy crisis took hold in 2021.

What the declaration means

Lane's formulation was precise. The cycle that dealt with the price shocks of 2021 and 2022, the energy spike after Russia's invasion of Ukraine and the pandemic-era supply chain blockages, has been removed from the system. The deposit rate, which peaked at 4% in September 2023, now stands at 2% after a series of cuts over the past year. But he was equally clear that the ECB's work is not complete in any broader sense. New shocks are already hitting the system, from volatile energy markets to exchange-rate moves, and the central bank must ensure that any deviation from target does not become embedded in medium-term expectations.

The distinction matters. For two years the ECB's policy framework was dominated by a single, overwhelming supply-side shock. That phase required a forceful, unambiguous response. The current environment is messier. Inflation is at target, but the forces holding it there are a mix of fading energy base effects, weak domestic demand and a still-tight labour market in several member states. Monetary policy must now navigate a narrower path: restrictive enough to keep expectations anchored, but not so restrictive that it chokes a recovery that has yet to take hold.

Markets already pricing the next move

Money markets have not waited for the ECB's next meeting. Forward curves imply a further quarter-point cut to 1.75% by the end of 2025, a view that aligns with the tone from Sintra. Lane did not push back against that pricing. He acknowledged that cyclical movements a bit lower are possible, and that the Governing Council will stand ready to adapt. The language marks a shift from the data-dependent, meeting-by-meeting caution of late 2024 to a more explicit acknowledgment that the bias has turned.

That bias is not universally shared across the Governing Council. Isabel Schnabel, the board member responsible for market operations, has repeatedly warned that services inflation remains sticky and that wage growth, while moderating, still runs above levels consistent with 2% inflation over the medium term. But the centre of gravity has moved. The hawks who argued for keeping rates at 4% well into 2024 have been quiet since the June cut. The debate now centres on pace and terminal rate, not direction.

Wunsch signals downside risks to growth

Pierre Wunsch, governor of the National Bank of Belgium and a member of the Governing Council, offered the clearest articulation of the growth concern. Speaking on Monday evening, he said risks to both inflation and growth are now tilted to the downside. Europe has endured two years of relatively slow growth, he noted, and any recovery may be delayed by global uncertainty. If the ECB has to move again, he added, it will probably be to the downside, a further cut. He was not pleading for one, but the framing was deliberate.

Wunsch's intervention carries weight. Belgium holds the rotating presidency of the Council of the European Union until the end of June, and he has been among the more hawkish voices on the Council during the tightening phase. His shift signals that the growth-inflation trade-off has changed. The ECB's own staff projections, published in June, show GDP growth of 0.9% for 2025 and 1.4% for 2026, figures that assume a gradual recovery in private consumption and investment. If those assumptions prove optimistic, the case for a lower terminal rate strengthens.

The new monitoring framework

Lane described a monitoring framework that looks very different from the one used during the inflation surge. The ECB is now watching three primary channels: energy market moves, exchange rates, and inflation expectations. The aim is to avoid overreacting to small deviations while not overlooking persistent factors that could shift the medium-term outlook. Domestic price pressures, particularly in services, remain the key gauge. The negotiated wage growth tracker, which the ECB publishes quarterly, will be scrutinised for signs that the 2024-25 wage agreements are feeding through into unit labour costs at a pace consistent with the target.

Exchange rates add a layer of complexity. The euro has appreciated modestly on a trade-weighted basis since the start of the year, helped by the interest-rate differential with the United States narrowing as the Federal Reserve holds rates steady. A stronger euro dampens imported inflation but also weighs on export competitiveness, particularly for the German manufacturing sector that is already struggling with structural headwinds. The ECB does not target the exchange rate, but it cannot ignore it.

Production weakness the missing piece

Wunsch singled out production data as the critical variable for the coming months. Industrial output across the eurozone has been contracting on a year-on-year basis for much of the past two years, with Germany's factory sector in recession since early 2023. The ECB's June projections assume a turnaround in the second half of 2025, driven by easing financing conditions and a recovery in foreign demand. If that turnaround fails to materialise, the central bank may need to be, in Wunsch's words, "a bit more supportive".

The production gap is not evenly distributed. France and Spain have seen more resilient industrial activity, supported by domestic demand and, in Spain's case, a tourism boom that spills over into services and construction. Italy's manufacturing has held up better than Germany's, though it remains below pre-pandemic levels. The divergence complicates a single monetary policy. A rate cut that helps German exporters risks overheating the Spanish housing market, where prices have risen sharply since 2022.

Fiscal policy absent from the conversation

What was striking in Sintra was the near-absence of fiscal policy from the official discourse. The ECB's mandate is price stability, not growth, but the two are linked. The European Commission's latest forecasts show the aggregate eurozone fiscal stance turning mildly restrictive in 2025 as pandemic-era support measures expire and the Stability and Growth Pact's revised rules begin to bite. Germany's debt brake, France's deficit reduction plan, and Italy's negotiation with Brussels over its structural primary balance all point to a drag on demand at the very moment monetary policy is easing.

Lane did not mention fiscal policy in his CNBC interview. Wunsch alluded to global uncertainty but not to domestic fiscal consolidation. The silence is understandable, central bankers avoid commenting on elected governments' budgets, but it leaves a gap in the policy mix. If the ECB cuts rates to support growth while governments tighten belts, the net effect may be neutral at best. The next European Council summit in October, where the 2025 budgetary plans will be assessed, will be as important for the monetary outlook as any inflation print.

What happens next

The immediate calendar is clear. The Governing Council meets on 17 July in Frankfurt, where no change is expected. The September meeting, accompanied by new staff projections, is the first live opportunity for a cut to 1.75%. Between now and then, the ECB will receive the June inflation breakdown, the second-quarter wage tracker, and the July PMI surveys. A surprise in any of those, particularly a rebound in services inflation or a sharp drop in the composite PMI below 50, could shift the September debate. For now, the central case is a quarter-point cut in September, a pause in October, and a final move to 1.5% in December if the data cooperate. The cycle is done; the calibration has begun.