ECB cuts deposit rate to 2% as inflation dips below target

The European Central Bank lowered its deposit facility rate by 25 basis points to 2% on Thursday, the third consecutive quarter-point reduction since the Governing Council began unwinding the most aggressive tightening cycle in the euro's history. The move had been priced with near certainty by money markets, yet the accompanying projections and Christine Lagarde's press conference revealed a central bank less comfortable with the inflation outlook than the headline figure suggests.

Inflation below target but core pressures persist

Euro area headline inflation dipped to 1.9% in May, according to Eurostat's preliminary estimate, the first reading below the ECB's 2% medium-term target since mid-2021. Energy prices and a stronger euro have done much of the work. The ECB's new staff projections, also released Thursday, show headline inflation averaging 2% this year and 1.9% in 2026, each revised down by 0.3 percentage points from the March round.

Strip out energy and food, however, and the picture changes. Core inflation was revised up to 2.4% for 2025 from 2.2% in March, and the bank now sees it at 2.1% next year rather than 2.0%. Services inflation, the component most closely watched for signs of domestically generated price pressure, has barely budged. Lagarde acknowledged the divergence, noting that the outlook for euro area inflation is more uncertain than usual.

A dissenting voice on the Governing Council

Lagarde confirmed that one member of the 26-strong Governing Council voted against the cut. The ECB does not name dissenters, but the split underscores a debate that has been running for months: whether the disinflation process is secure enough to keep cutting, or whether the stickiness of services prices and wage growth argues for a pause. The deposit rate at 2% sits roughly in the middle of most estimates of the neutral rate, the level that neither stimulates nor restricts activity, which raises the bar for further moves.

Growth forecasts held despite stronger start to the year

The euro area economy expanded by 0.3% in the first quarter of 2025, a touch above the ECB's earlier expectation. Lagarde told CNBC the figure was clearly giving momentum to the growth outlook and might yet be revised higher. Yet the bank left its full-year growth projection unchanged at 0.9%, citing a weaker outlook for the remainder of the year. The projection assumes that rising government investment in defence and infrastructure will increasingly support activity over the medium term, offsetting the drag from trade policy uncertainty.

That trade uncertainty is dominated by the United States. President Donald Trump's tariff programme, particularly the sector-specific duties on steel and aluminium and the threatened levies on automotive imports, targets industries that account for a disproportionate share of euro area exports. The ECB's baseline assumes the EU's retaliatory measures remain on pause, but the risk of escalation is built into the forecast ranges.

Analysts split on the path ahead

The market reaction was muted. The Stoxx 600 erased early gains to trade 0.2% lower, while the euro rose 0.6% against the dollar, suggesting investors had already positioned for the cut and were parsing the forward guidance for clues on July. The ECB gave almost none. Lagarde repeated the familiar formulation that the Governing Council is not pre-committing to a particular rate path and will follow a data-dependent, meeting-by-meeting approach.

That vacuum has left analysts divided. Irene Lauro, euro zone economist at Schroders, argued that with rates now at the midpoint of the estimated neutral range, the bar for further cuts has risen and the ECB can afford to shift from urgency to patience. She sees a pause in July as the most likely outcome, particularly given the absence so far of hard evidence that tariffs are weakening the economy.

Natasha May, global market analyst at J.P. Morgan Asset Management, takes the opposite view. With inflationary pressures receding fast and growth headwinds picking up, she contends the ECB is underestimating the risk of undershooting its target. Trade tensions, she argues, could have more of an impact on inflation in the medium term by depressing demand rather than pushing up prices. In her assessment, the case for another rate cut is crystal clear, even if some Governing Council members are advocating for a July pause.

Transmission and the neutral rate debate

The ECB's statement emphasised the strength of monetary policy transmission, the process by which rate changes feed through to financing conditions, credit volumes and ultimately spending and inflation. Bank lending surveys have shown a sharp tightening of credit standards over the past two years, and the stock of loans to non-financial corporations has been contracting. The question is how much of that contraction reflects restrictive policy versus weak demand.

Estimates of the neutral rate vary widely, from as low as 1.5% to as high as 3% in real terms, depending on assumptions about potential growth, the natural rate of interest and the equilibrium real exchange rate. With the deposit facility rate at 2% and inflation at 1.9%, the ex-post real rate is barely positive. If the neutral real rate is close to zero, as some models suggest, policy may already be near neutral. If it is higher, there is room to cut further.

Fiscal policy enters the frame

The ECB's projection round incorporates, for the first time, the fiscal stimulus from the EU's RePowerEU and defence initiatives. Germany's constitutional amendment to exempt defence spending above 1% of GDP from the debt brake, and the €500bn infrastructure fund, are expected to add meaningfully to demand from 2026 onwards. The bank estimates the combined fiscal impulse could lift euro area GDP by 0.3 to 0.5 percentage points per year over the medium term.

That fiscal tailwind complicates the monetary calculus. If government spending picks up just as the private sector begins to feel the full lagged effect of past rate hikes, the case for restrictive policy strengthens. Conversely, if the fiscal boost is back-loaded and the near-term outlook darkens because of trade disruption, the argument for front-loading cuts gains traction. The Governing Council's divergence likely reflects different weightings of these scenarios.