ECB set for third rate cut as tariff uncertainty clouds growth outlook

The European Central Bank is on the brink of delivering its third interest rate cut of the year on Thursday, a move that would have looked unlikely only a few weeks ago. Financial markets are pricing a 94% probability of a quarter-point reduction, which would lower the deposit facility rate to 2.25% from the 4% peak reached in mid-2023. The shift reflects a rapid reassessment of the euro area's growth prospects after the United States unleashed a fresh round of tariff threats earlier this month, only to partially suspend them days later.

Tariff shock forces ECB back to cutting cycle

As recently as the March meeting, the ECB had signalled growing comfort with the restrictive stance of policy. The Governing Council changed its language to say monetary policy was "becoming meaningfully less restrictive", dropping the previous description of policy as simply "restrictive". That tweak was widely read as a hint that the cutting cycle might pause, especially after Germany's fiscal pivot and higher defence spending across Europe brightened the near-term growth outlook.

Carsten Brzeski, global head of macro at ING, captured the consensus view in a note on Monday. He wrote that the ECB had seemed set for a pause, with rates at the upper end of neutral estimates and the German fiscal u-turn improving the growth picture. Then came what he called "Liberation Day", the Trump administration's sweeping tariff announcements on 2 April, and the calculus changed. "However, since 'Liberation Day', a pause is no longer an option," Brzeski said, concluding that the ECB is now forced to cut.

Markets all but certain of quarter-point move

LSEG data shows traders see only a 6% chance of a larger 50 basis point reduction. The quarter-point move would bring the deposit rate to 2.25%, exactly at the top of the ECB's own estimated range for the neutral rate, the level at which policy neither stimulates nor restricts the economy. That range, 1.75% to 2.25%, has been the subject of intense debate among policymakers and economists for months. A cut on Thursday would effectively place policy at the threshold of neutrality.

Inflation has cooperated. Euro area price pressures have consistently remained below 3% and have been closing in on the 2% target. Yet growth has been lacklustre, and the tariff turbulence has added a fresh layer of uncertainty. Ryan Djajasaputra, economist at Investec, noted that many announced tariffs have been put on hold or reduced, but the outlook remains murky. "Uncertainty remains high and there is still no guarantee individual countries or the EU will be able to agree deals with the US," he wrote, adding that the unpredictability of US policy supports the case for a trim.

Neutral rate debate shifts with new cut

The question of where neutral actually lies has practical consequences. If 2.25% is the upper bound, the ECB would be signalling that policy is no longer restrictive after Thursday. Brzeski argues the central bank will have to change its communication, flagging that a 2.25% deposit rate "would now be within the range of neutral interest rates". That would represent a significant milestone: the end of the restrictive phase that began with the first hike in July 2022.

Not all analysts agree on the communication shift. Economists at Deutsche Bank Research believe the ECB will keep its language unchanged on Thursday. They argue that the current wording, emphasising data dependence and no pre-commitment to a specific rate path, carries an implicit dovish lean when combined with inflation returning to target. That "open-ended" formulation, they say, allows the policy stance to remain restrictive, move to neutral, or turn stimulative depending on incoming data.

Communication challenge for Lagarde

Christine Lagarde faces a delicate messaging task at her press conference. The ECB president must acknowledge the tariff shock without appearing to panic, and she must address the neutral rate threshold without boxing the Governing Council into a corner. The March language change was carefully calibrated; a further tweak so soon risks looking reactive. Yet ignoring the shift in external conditions would strain credibility.

The Governing Council's own forecasts will be scrutinised. The March staff projections saw inflation averaging 2.3% in 2025 and 1.9% in 2026, with GDP growth of 0.9% and 1.4% respectively. Those numbers predate the latest tariff escalation. Private sector forecasters have already begun marking down growth expectations for the second half of the year. The ECB's next full set of projections arrives in June, by which point the trade picture may be clearer, or more confused.

Open-ended path leaves June in play

Deutsche Bank's economists emphasise that the ECB's guidance, decisions made meeting by meeting, data dependent, no pre-commitment, technically allows for a pause in June. Their baseline still assumes further cuts, but the wording preserves optionality. That matters because the tariff situation could evolve in either direction. A US-EU trade deal would remove a major headwind; a fresh escalation would deepen the growth scare. The ECB has built itself a framework that can accommodate either outcome.

Investec's Djajasaputra puts it bluntly: "Beyond April's meeting, the outlook for ECB interest rates is one clouded by and beholden to White House policy decisions." He expects another cut later this year, but the timing hinges on economic data and "other economic developments", code for whatever the US administration does next. That is a remarkable position for a major central bank: its rate path effectively hostage to a foreign government's trade whims.

Trade policy now drives European monetary outlook

The irony is that the ECB spent years insisting its policy was domestically focused, driven by euro area inflation and growth. Now, the dominant variable is US trade policy. The partial suspension of tariffs has not removed the uncertainty; it has merely replaced one unknown with another. Will the 90-day pause lead to negotiated settlements? Will the US impose sectoral tariffs on autos or pharmaceuticals? Will retaliation escalate? Each scenario implies a different growth trajectory for the euro area, and thus a different appropriate interest rate.

European leaders have responded with a mix of negotiation and preparation. The European Commission has offered zero-for-zero tariff deals on industrial goods while readying countermeasures. Germany's fiscal package, approved in March, provides a domestic buffer. But the transmission from trade policy to monetary policy runs through confidence and investment, channels that are slow, opaque, and hard to forecast. The ECB is cutting not because the data demands it today, but because the risk of waiting has become asymmetric.