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ECB Faces Economic Crossroads Amid Trump’s Return

LONDON – The European Central Bank (ECB) is set to convene on Thursday, marking its first meeting since Donald Trump resumed the U.S. presidency. This development casts a shadow over the euro zone’s already faltering economy, with potential tariff threats from Washington adding to the uncertainty of the economic landscape.

Market participants anticipate a further reduction in interest rates, leading to speculation about whether the ECB will offer any insights regarding future monetary policy directions.

According to Bruno Cavalier, chief economist at Oddo, observers expect President Christine Lagarde to indicate that additional rate cuts remain a possibility.

Key Questions for Market Consideration

As traders prepare for the ECB meeting, five pivotal questions arise:

1. What Actions Will the ECB Take?

A majority consensus predicts that the ECB will reduce the key deposit rate by 25 basis points to reach 2.75%. This move has been fully incorporated into market expectations, particularly following the ECB’s removal of prior commitments to maintain restrictive rates in its guidance from December.

Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, noted, “There has been no change to the outlook since December.”

2. How Will Trump’s Return Influence the ECB’s Tariff Concerns?

Currently, economists believe Trump’s return does not significantly alter the ECB’s perspective on tariff-related risks. Despite refraining from immediate tariff implementations, Trump has criticized trade terms with the European Union and identified Canada, Mexico, and China as potential targets.

During a recent address to the World Economic Forum, Trump warned that tariffs could be levied against economies that manufacture products outside the U.S. Although the initial response appears less aggressive than anticipated, the situation remains fluid.

For the ECB, the crucial issue is the effect of tariffs on inflation in the euro zone, which could occur both directly and indirectly through demand fluctuations. Lagarde’s statement that the bank is “not overly concerned” about the inflationary effects from Trump’s policies leads some analysts at ABN AMRO to conclude that tariffs may primarily be detrimental to growth.

3. How Much Further Does the ECB Need to Cut Rates?

Traders are forecasting nearly four rate reductions from the ECB this year, with some policymakers openly supporting this view, suggesting rates could approach 2%. This trajectory would place rates within the range of the neutral rate, which does not impede or spur economic growth.

However, some policymakers maintain a cautious stance on the pace of these cuts. Isabel Schnabel, a leading hawk, cautioned that the bank must carefully consider the extent and speed of rate reductions. PIMCO portfolio manager Konstantin Veit noted that once rates hit 2.5%, more deliberation will be required on future maneuvers, despite potential economic weaknesses pushing rates down to 1.75%.

Lagarde has indicated that the neutral rate is estimated to be between 1.75% and 2.25%.

4. How Concerning is the Recent Rise in Inflation for the ECB?

Economists generally view the rise in inflation as manageable. In December, inflation reached 2.4%, its highest level since July, primarily due to increasing energy costs and persistent inflation in the services sector, which remains at around 4%.

This uptick aligns with the ECB’s forecasts, and chief economist Philip Lane is optimistic that slowing wage growth will lead to reduced inflation in services. He has also warned that maintaining high rates for extended periods could inadvertently drive inflation below target levels.

Though the ECB focuses on inflation nearing 2%, Danske Bank’s chief analyst, Piet Christiansen, argues that growth is equally relevant in gauging future inflation trends.

5. What Happens If the Fed Halts Rate Cuts?

The ECB might consider tempering its cuts based on the reasons behind the Fed’s decisions. Uncertainties in the U.S. inflation outlook have led to fluctuating expectations surrounding federal rate cuts this January, with institutions like BofA and BNP Paribas predicting a hold from the Fed this year.

Ducrozet of Pictet noted that if the Fed refrains from cutting rates due to robust economic conditions, this could bode well for Europe, possibly leading the ECB to adopt a more cautious cutting strategy. Conversely, if the Fed holds rates amid a stagflation environment, the implications for ECB policy would be less favorable, regardless of any shifts in the euro’s value against the dollar.

Source
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