The ECB will keep all options open

There is little doubt that the ECB will shave another 25bp off its policy rates next week. The ECB will keep its options fully open. We still believe that this may be the last rate cut, but risks remain skewed to an additional cut. If this does materialise, we believe September is a more likely timing than July.

President Lagarde mentioned “uncertainty” 15 times during her previous press conference. Heading into the June meeting, uncertainty hasn’t exactly lessened.

The Governing Council can probably conclude that inflation remains on track to their target. Recent data remains encouraging, but not unequivocally so (see below). This creates some doubts about the speed at which inflation will converge to 2%, and whether this convergence is durable.

Moreover, the external environment has become even less clear. Trump’s threat of a 50% tariff on European goods poses a key downside risk to the economy, but it has also put pressure on negotiators to reach a trade deal quickly. Meanwhile, the baseline outlook for the global economy has arguably improved somewhat, after the US struck some first trade deals and given the tariff-truce between the US and China.

The greater uncertainty also comes with a greater plausible range of outcomes. And, as inflation is getting closer to the target, this means that downside risks are also increasing. Separately, the ECB hasn’t really pushed back to the market pricing more than 95% chance of a rate cut – except for Holzmann, who recently argued the ECB should pause until September. In the current environment, the central bank probably wants to avoid surprising markets and injecting any additional volatility. All in all, we believe a very large majority will back a rate cut next week.

What’s next?

Barring new shocks, we maintain that 2% probably marks the low of the current cutting cycle.

In less volatile circumstances, policymakers might have flagged this more explicitly, and perhaps even in advance. But given the event risks, the ECB cannot afford to hint too much in any direction. The ECB needs optionality even more than it had in prior meetings. We expect the statement and Lagarde’s press conference to reflect this. Even suggesting a pause might tie policymakers’ hands more than they like: the July meeting takes place two weeks after the current deadline for US-EU trade negotiations.

The ECB’s main challenge is to avoid that this sounds overly dovish. Money market pricing has been biased to lower rates, and optionality could be interpreted as a dovish sign. Should market pricing for July shift too much towards another cut, we would expect some strategic “leaks” from ECB officials in the hours or days after the press conference. In fact, Holzmann’s plea to leave rates on hold until September may have been a first stab at softening the markets’ expectations.

Risks centre on September

Our base case is, again, that the ECB is done. But this is a low conviction call, given the fundamental uncertainty.

Indeed, in the current environment, we cannot rule out another rate cut in July. However, we believe this would require the materialisation of a severe event risk, such as a failure of US-EU trade talks. If negotiations do not progress and Trump decides to impose a 50% tariff as threatened, this would be a major shock to the Eurozone economy that warrants an intervention by the ECB. Crucially, this scenario would probably warrant more cuts than just July.

Barring such event risk, we would argue that any extra rate cut is more likely to materialise in September. With risks becoming more two-sided, waiting has several advantages. First and foremost, it gives the ECB more time to evaluate incoming data. In September, the ECB will also have a new set of economic projections to work with. Plus, a pause would help communicate that the ECB expects it is at (or near) the end of the easing cycle – without having to explicitly say this.

Notably, Stournaras, traditionally a dove, has also advocated a pause after the June meeting.

Given the uncertainty, scenario analysis will be an important part of the ECB’s assessment of the economic outlook. But they will have to provide central projections. We believe the growth forecast for 2025 and 2026 may be revised down somewhat. Meanwhile, headline inflation looks a bit more benign this year, but we see upside risks to the ECB’s 2026 forecast.

Our current set of projections is based on a scenario where many US trading partners will face some level of tariffs. For the EU, we have assumed that US sectoral tariffs and a universal tariff on other EU goods will average out to about 15-20%.

Compared to our baseline, the outlook has arguably improved somewhat. Trump’s reciprocal tariffs have been postponed pending talks. A couple of countries have already struck trade deals with the US, and the US and China have agreed on a truce. For many other countries, including Europe, it is as of yet unclear whether negotiators can reach an agreement.

By comparison, the ECB’s previous projections predate Trump’s Liberation Day tariffs, and the subsequent developments that have taken place. So, a downgrade to the growth projections should not come as a surprise, particularly for this year and next.

That said, we do not expect the ECB to slash its GDP forecasts to the growth rates we are predicting. The staff projections generally only includes economic policies that are in place, or very likely to come into effect. The ECB will undoubtedly have alternative scenarios that include various trade and tariff hypotheticals. So, we expect the ECB to present somewhat lower growth forecasts, while maintaining that the risks to that baseline are skewed to the downside.

Because part of the improvement in the inflation outlook is due to the unexpected appreciation of the euro, as well as lower energy prices. But for inflation to converge durably, domestic price pressures still need to slow further as well. There, too, signs are tentatively positive. However, there are some caveats too. First, the momentum of services prices has recently accelerated again, sowing some doubt as to how quickly the disinflationary trend will continue from here.

Secondly, the ECB’s indicator of negotiated wages showed a marked decline in Q1. That’s an encouraging sign. But it is also largely driven by a deceleration in Germany, where a big gap is opening up between the wage data that include and exclude one-off pay. This mirrors the sharp rise in 2024Q1, when pay deals included larger lump sums. Meanwhile, Italian pay growth rebounded a bit stronger than we had expected. So, again, the jury is out whether this deceleration in wages will continue, or whether this trend is overstated due to high incidental compensation last year.

Although we are less optimistic about the growth outlook than the central bank, our inflation projections are actually higher than the ECB’s. The new set of projections may shift some of the expected inflation from 2025 to 2026, owing to the decline in energy prices. But, again, we do not believe that the ECB’s 2026 forecast will be raised to the 2.3% we are forecasting. This persistent difference is, again, due to the assumptions that we have already embedded relating to tariffs – not only imposed by the US, but also the rebalancing tariffs that the EU may introduce.

Crucially, our scenario underlines the difficult situation the ECB is in: Even though the risks to Eurozone growth remain skewed to the downside, this is not necessarily the case for inflation. Whilst US tariffs would probably have an immediate negative effect on Eurozone activity and prices, one also needs to account for the likelihood that the European Union would retaliate. If trade negotiations fail and both sides impose tariffs, the outcome would probably be stagflationary.

How durable is the convergence of inflation?

Pending new developments in these trade negotiations, the current path for inflation looks a bit more benign than in our previous forecast, and the ECB can conclude that headline inflation continues to converge to the 2% target. The key questions have not changed. How quickly will the remaining gap be closed? And is this convergence durable?

Because part of the improvement in the inflation outlook is due to the unexpected appreciation of the euro, as well as lower energy prices. But for inflation to converge durably, domestic price pressures still need to slow further as well. There, too, signs are tentatively positive. However, there are some caveats too. First, the momentum of services prices has recently accelerated again, sowing some doubt as to how quickly the disinflationary trend will continue from here.

Secondly, the ECB’s indicator of negotiated wages showed a marked decline in Q1. That’s an encouraging sign. But it is also largely driven by a deceleration in Germany, where a big gap is opening up between the wage data that include and exclude one-off pay. This mirrors the sharp rise in 2024Q1, when pay deals included larger lump sums. Meanwhile, Italian pay growth rebounded a bit stronger than we had expected. So, again, the jury is out whether this deceleration in wages will continue, or whether this trend is overstated due to high incidental compensation last year.

The labour market has come off the boil, but remains very tight. Unemployment remains at a historic low and vacancy rates are still close to past cyclical highs. This implies that any positive turn of events, such as a potential trade deal between the EU and the US could relatively quickly reignite wage pressures. That is yet another reason for the ECB to keep a steady hand.