ECB cuts rates to 2.75% as eurozone economy flatlines

The European Central Bank cut its deposit facility rate by a quarter of a percentage point to 2.75% on Thursday, the fifth reduction since June last year, as the eurozone economy failed to grow in the final three months of 2024. The move had been widely anticipated by financial markets, which now price in a further percentage point of easing before the year is out.

Growth stalls across the bloc's largest economies

The immediate backdrop was a run of data showing the currency area's three biggest economies all losing momentum. Eurostat's flash estimate put quarterly GDP growth at zero for the bloc as a whole in the fourth quarter. Germany, the largest member, contracted by 0.2%. France shrank by 0.1%. Italy recorded no growth at all. The figures confirm what business surveys have been signalling for months: the manufacturing recession that began in 2022 has spread to services, and domestic demand is not picking up the slack.

For the ECB, the stagnation creates a dilemma. Inflation has fallen sharply from its double-digit peak in late 2022, but the last mile back to the 2% target is proving sticky. Services inflation, driven by wage growth in labour-intensive sectors, remains above 3%. The bank's own projections show headline inflation averaging 2.3% this year and 1.9% in 2026, but the path is littered with assumptions about energy prices, fiscal policy and global trade that could easily be upended.

Lagarde acknowledges persistent headwinds

At her press conference, Christine Lagarde, president of the European Central Bank, struck a cautious tone. The five cuts since June, taking the deposit rate from a peak of 4%, were consistent with inflation returning to target over the medium term, she said. Yet she warned that "headwinds" meant the economy was "set to remain weak in the near term", adding that "consumer confidence is fragile". The phrase "fragile" was deliberate. Household saving rates have risen sharply since the pandemic, and despite real wage growth turning positive last year, consumers have chosen to rebuild balance sheets rather than spend.

Lagarde also pointed to the labour market. Unemployment remains at historic lows, but vacancy rates are falling and hiring intentions have softened. Wage growth across the single currency area is moderating, and many companies are absorbing higher labour costs in thinner margins rather than passing them through to prices. That dynamic helps disinflation but signals weak pricing power, a hallmark of an economy operating below potential.

Trade risks and the Trump factor

The most striking passage in Lagarde's remarks concerned global trade. Without naming Donald Trump directly, she said: "Greater friction in global trade would make the inflation outlook in the euro area more uncertain." The reference was unmistakable. The newly inaugurated US president has threatened universal tariffs of 10% to 20% on all imports, with higher levies on Chinese goods and specific measures targeting the European automotive sector. If implemented, such tariffs would raise input costs for European manufacturers, disrupt integrated supply chains and potentially trigger retaliation, a stagflationary shock the ECB's models are ill-equipped to handle.

The contrast with the Federal Reserve was stark. A day earlier, the Fed held its policy rate in the 4.25% to 4.5% range, citing a US economy that expanded at an annualised 2.3% in the fourth quarter and a labour market that continues to generate jobs at a pace well above what policymakers consider sustainable. The divergence means the euro-dollar exchange rate has become an additional channel for monetary transmission: a weaker euro imports inflation via energy and commodities, complicating the ECB's task.

Transmission: mortgages revive, business lending stalls

One area where lower rates are visibly working is the mortgage market. Lagarde noted that the cuts had "sparked the European mortgage market back into life". Data from the ECB's own monetary statistics show new lending to households for house purchase picked up in the second half of 2024, particularly in France and the Netherlands, where fixed-rate products reprice quickly. In Germany, where long fixed periods dominate, the effect is slower but visible in new origination volumes.

Business lending tells a different story. Loans to non-financial corporations continued to contract in nominal terms through the end of last year. The ECB's bank lending survey shows credit standards tightening for the seventh consecutive quarter, with banks citing deteriorating economic outlook and collateral values as the main drivers. Demand for loans remains weak: firms are not investing because they do not see the return, not because they cannot borrow. That distinction matters. Monetary policy can lower the price of credit, but it cannot create demand where none exists.

Analysts: policy still restrictive, more cuts needed

Carsten Brzeski, global head of macro at ING, was blunt in his assessment. "At 2.75%, the deposit interest rate is still restrictive, too restrictive for the eurozone economy's current weak state," he said. Brzeski argued that the ECB would need to go further to reverse the poor run of data. He also highlighted a less discussed constraint: recent increases in global long-term interest rates, driven by US fiscal expectations and term premium repricing, have pushed up borrowing costs for eurozone governments. That tightens financial conditions independently of the ECB's policy rate and weighs on public spending capacity just as several member states, France and Italy prominent among them, are attempting fiscal consolidation.

Mark Wall, chief European economist at Deutsche Bank, went further. He believes the ECB is systematically underestimating the weakness of the economy and the speed with which borrowing costs must fall to support spending. "There is really no reason to think the ECB won't continue to cut rates, at least to a neutral level [of 2% to 2.5%], and we think quite probably below neutral by year-end," he said. Wall's view implies a deposit rate of 1.5% to 1.75% by December, roughly 100 to 125 basis points below where markets are currently pricing. The gap reflects a deeper disagreement about the neutral rate itself. If potential growth has fallen structurally, due to demographics, weak productivity and the energy transition, then the neutral rate may be lower than the ECB's working assumption of 2% to 2.5%.

Political instability compounds economic uncertainty

Both analysts pointed to a factor the ECB cannot control: political fragmentation. France has cycled through three prime ministers in six months. Germany's coalition collapsed in November, triggering an election scheduled for February 23. Italy's government is stable but its fiscal room is minimal. In this vacuum, Brzeski noted, "political instability and uncertainty in many countries will force the ECB to continue doing the heavy lifting." The central bank becomes the only game in town, a role it was not designed for and one that risks politicising monetary policy further.

The ECB's own economic bulletin, published alongside the decision, spelled out the feedback loop. Uncertainty about the outlook and volatile global markets are persuading both businesses and consumers to keep their wallets closed. That weakness feeds back into lower investment and hiring, which validates the pessimism. Breaking the loop requires either a clear improvement in external demand, unlikely with the US turning protectionist and China managing a slowdown, or a decisive shift in domestic sentiment. The latter depends on policy clarity that is currently absent.

What the next meetings will watch

The governing council meets again on March 6, April 17 and June 5. By March, the ECB will have new staff projections incorporating the latest national accounts, the February German election result and whatever trade measures the Trump administration has enacted. The April meeting coincides with the first round of the French presidential election campaign (though the vote itself is not until 2027, the positioning begins early). June brings the first post-election German budget negotiations. Each of these events could shift the baseline enough to alter the pace of easing.