ECB cuts deposit rate to 2.5% as trade risks and German spending plans cloud outlook

The European Central Bank lowered its deposit facility rate to 2.5% on Thursday, the sixth consecutive reduction since the Governing Council began easing in June 2024. The main refinancing rate, which determines the cost of liquidity for the banking system, was reduced to 2.65%. The move had been widely priced into money markets, but the accompanying forecasts and commentary revealed a central bank increasingly caught between a disinflation process that is broadly on track and a political environment that could yet blow it off course.

Growth downgrade signals deeper malaise

The ECB's new staff projections cut the 2025 growth forecast for the euro area to 0.9%, down from 1.1% in December, and the 2026 forecast to 1.2% from 1.4%. The 2027 projection stands at 1.3%. These are not recession numbers, but they underscore how little momentum the currency union carries. Private consumption has been slower to recover than the ECB anticipated a year ago, business investment remains subdued, and the manufacturing sector, still the backbone of the German and Italian economies, has been in contraction for the better part of two years.

The bank's own analysis attributes much of the downgrade to weaker net exports. That is a direct read-across from the trade tensions Lagarde highlighted. The United States has imposed 25% tariffs on steel and aluminium imports and has threatened broader measures against European automotive and agricultural goods. If those threats materialise, the ECB estimates the hit to euro area GDP could reach 0.3 to 0.5 percentage points over a two-year horizon, depending on the scope of retaliation and the effect on financial conditions.

Trade war risk forces a looser bias

Lagarde was unusually direct in her press conference. She described the outlook as "risks, uncertainty all over" and explicitly linked the decision to keep cutting to the possibility of a transatlantic trade war. The logic is straightforward: if external demand collapses, domestic demand must carry more weight, and lower borrowing costs are the ECB's primary lever to support it. The deposit rate at 2.5% is now 150 basis points below the peak of 4% reached in September 2023, a pace of easing that outstrips the Federal Reserve's current trajectory.

The ECB's monetary policy statement noted that financing conditions remain restrictive but are easing gradually. Bank lending surveys show credit standards for firms have stopped tightening, though demand for loans remains weak. The transmission of the rate cuts to household mortgage rates has been faster than in previous cycles, with the average rate on new fixed-rate mortgages in the euro area falling below 3% in January for the first time since 2022.

Germany's fiscal pivot adds a new variable

While the ECB worries about external shocks, the biggest domestic policy shift in years is taking shape in Berlin. The CDU/CSU and SPD, currently negotiating a coalition agreement, have agreed in principle to create a €500 billion special fund for infrastructure investment over ten years, financed by borrowing outside the constitutional debt brake. They also plan to exempt defence spending above 1% of GDP from the brake's constraints. If passed by the outgoing Bundestag before the new parliament sits, the package could add 0.4 to 0.6 percentage points to German GDP growth annually over the fund's life, according to early estimates from the Bundesbank and the European Commission.

Lagarde called the German proposal a "work in progress" and declined to quantify its impact. That caution is warranted. The fund's design, off-budget, time-limited, focused on infrastructure, means its multiplier effects depend heavily on project selection and implementation capacity. German municipalities and states have a poor track record of spending capital budgets quickly. More immediately, the sheer scale of new borrowing, combined with higher defence outlays, will increase the supply of German government bonds at a moment when the ECB is reducing its portfolio under quantitative tightening. That could push up term premia and long-term yields, partially offsetting the stimulus from short-rate cuts.

Inflation: the last mile remains sticky

The ECB's confidence that inflation is returning to target rests on a distinction between headline and underlying dynamics. Headline inflation was 2.4% in February, but the bank's preferred measure of domestic price pressures, services inflation, remains at 3.7%. Energy-price-driven inflation is projected to average 2.3% in 2025, above the 2% target, largely because base effects from the 2022-23 energy shock are no longer pulling the index down. Food inflation has proven more persistent than expected, and wage growth, while moderating, is still running above 4% year on year in the negotiated wage tracker.

The Governing Council's language on inflation was carefully calibrated. It repeated that the disinflation process is "well on track" but dropped the phrase "sufficiently restrictive" that had appeared in previous statements. That omission signals the Council believes it is approaching the neutral rate, the level that neither stimulates nor restricts activity, but does not want to pre-commit to a pause. Money markets currently price two further 25 basis point cuts by June, taking the deposit rate to 2.0%. Whether the ECB delivers them will depend on the March and April wage rounds and the April inflation flash estimate.

The neutral rate debate

Behind the scenes, the debate over where neutral lies has intensified. The ECB's own models place the nominal neutral rate somewhere between 1.75% and 2.25%, implying a real neutral rate near zero given the 2% inflation target. But those estimates assume potential growth of around 1.25% and a stable savings-investment balance. Germany's fiscal expansion, if it materialises, shifts that balance: higher public investment raises the natural rate of interest, all else equal. Some Governing Council members, particularly from the north, have argued in recent speeches that the ECB should not cut much below 2% without clearer evidence that inflation expectations are anchored. Others, notably from the south, see room to go lower given the trade shock risk.

This tension was visible in the voting. While the decision was unanimous, sources close to the Council say the discussion on the pace of further easing was "animated". The published accounts of the March meeting, due in four weeks, will clarify whether a minority argued for a larger 50 basis point move, as some market participants had speculated, or for a hold. For now, the Council has preserved optionality.

Banking sector transmission and profitability

The rate cuts are feeding through to bank balance sheets in uneven ways. Net interest margins at the euro area's significant institutions peaked in mid-2024 and have begun to compress as deposit repricing lags loan repricing. The ECB's latest banking supervision data show the average return on equity for significant institutions fell to 9.2% in the fourth quarter of 2024, down from 10.5% a year earlier. That is still above the cost of equity for most banks, but the trend is clear. The sector's excess liquidity, the deposits banks hold at the central bank above reserve requirements, has fallen from a peak of €4.7 trillion in 2022 to around €2.8 trillion as the ECB's targeted longer-term refinancing operations (TLTROs) mature and quantitative tightening proceeds.

This matters for transmission. Banks with high liquidity buffers pass rate cuts through to depositors more slowly, which supports their margins but dampens the stimulus to households. The ECB has resisted calls to remunerate minimum reserves at a lower rate than the deposit facility, a tool that would accelerate pass-through but hit bank profits. Lagarde reiterated that the current framework remains appropriate, but the issue will return if lending growth fails to pick up.