MNI SOURCES: Risks Tilt To Downside As ECB Mulls Path Below 2%

The likelihood that the European Central Bank will need to cut interest rates below 2% is increasing as the Governing Council becomes more convinced that inflationary risks are firmly to the downside amid extreme uncertainty around trade and the global economy, Eurosystem officials told MNI.

Previous expectations for policymakers to be able to fine tune the end of their easing cycle have been dashed by the unpredictability of U.S. President Donald Trump’s tariff moves and the response to it by other major economies, officials said. This prompted the ECB to shift to adjust its language in April, when it cut the deposit rate by 25 basis points to 2.25%, dropping an earlier reference to keeping rates restrictive and instead declaring that it would set them at an “appropriate level”.

“I imagine the discussion in June will be very similar to the one we had in April, and in July, we’ll see the same,” one national central banker told MNI, adding that it was possible that events could remain volatile throughout Trump’s presidency. Another official also said that uncertainty would probably persist under Trump.

The Governing Council’s meeting ending on June 5 is likely to conclude with a further 25-basis-point reduction in the deposit rate to 2%, though some more hawkish officials will argue for a pause which others said was more likely to come in July. (See MNI SOURCES: ECB Heads For June Cut, But Debate To Be Lively)

“In my view, we need a further 25-basis-point cut, but then we'll see. I don't think a big step of 50 basis points, because there'll be huge uncertainty worldwide,” another official said, noting that the ECB’s three criteria of underlying inflation, headline inflation, and the transmission mechanism all call for easing next month. “It seems that these are all satisfied. So we continue for the 25-basis-point cut. Then we'll pause a little bit and reconsider the situation. It's because of uncertainty.”

NEW PROJECTION ROUND

The next meeting will see revised inflation projections, but the unusual potential for global shocks has some officials questioning their usefulness, with one even calling them “completely useless.”

Still, the ECB must be ready to respond when inflation or its projections fall below target just as it does when they rise above, another official said, even if that that does not mean overreacting to small deviations.

“There has to be some symmetry in the reaction function,” the source said, “But that doesn't mean we have to ramp up policy action if inflation or the medium-term target is say 1.9% or even at 1.8%, we can look through some below targeting inflation as we look through above target inflation at times.  However, if it comes in say persistently at 1.6% for a prolonged period, we will probably have to be more forceful in our action than currently envisaged in the baseline scenario.”

March’s projection had inflation falling to 1.9% in 2026 before edging up to 2.0% in 2027.

VOLATILE SCENARIOS

“In the scenario we will present in June, we will be either above or below 2% in the medium term. If we plug in the market curve and it gives us inflation below the target, then we have to lower the curve. If it gives us inflation above the target, we have to raise the curve,” another source said.

Tariffs could lead to a further appreciation of the euro, and disinflationary impulses could be strengthened by a potential influx of Chinese goods diverted from the U.S.

Worrying scenarios for trade include increased barriers not only to the flow of goods, but also for services, one official said. (See MNI: EU Countries See US Shift In Tone But Trade Deal Unlikely)

“That, for me, would be a concerning scenario,” the official said, adding that this was one of two potential “game-changers”.

“The worst scenario is a war of everyone against everyone. That scenario is far more worrying.”

An ECB spokesperson declined to comment.