In just one year the ECB halved its major policy interest rate. Can this decisive decision-making be justified on the basis of the evolution of inflation? There are clearly other considerations playing an important role in the ECB’s policy trajectory so far.
On June 5 the European Central Bank (ECB) cut its three key interest rates (the rate for main refinancing operations, the marginal facility lending rate and most importantly the rate on the deposit facility) by 25 basis points bringing its deposit facility rate to 2%. This eighth policy rate cut since June 2024 means that in one year’s time the ECB halved its base policy rate from 4% to 2%. The ECB deposit rate peaked in September 2023 at 4% and remained at that level for nine months.
It took the ECB, faced with escalating inflation, four years (between September 2019 and September 2023) to substantially tighten monetary policy with the deposit facility rate being pushed from – 0.5% to 4%. It took the ECB one year (from June 2024 to June 2025) to cut its base policy rate from 4% to 2%. Although the upward push (from – 0.5% to 4%) was more than double the downward move (from 4% to 2%), the fact that the latter took place within one single year supports the conclusion that the speed of the downward train was even more pronounced than the speed of the upward train.
Last April Christine Lagarde, the ECB president, argued that “most measures of underlying inflation” indicated that the ECB was on track to meet its 2% inflation target “on a sustained basis”. This benign evolution of projected inflation, formed together with the drastically increased uncertainty for the economic outlook essentially due to the trade wars unleashed by American president Donald Trump, the rationale for the ECB’s intense downward policy rate movement. A number of questions and critical considerations with respect to the ECB’s policy path are in order.
Below par
Let us first of all compare the policy rate decisions of the ECB with the evolution of inflation in the eurozone. The overall inflation rate which peaked at 10.6% in October 2022 came down substantially since then. At the beginning of this year the overall inflation rate stood at 2.5% and in May an annualized rate of 1.9% was reached according to Eurostat’s flash estimate. The medium term inflation objective of the ECB is an inflation rate of 2%. Core inflation, being the overall inflation rate corrected for the volatile energy and food components, stood in May at 2.3%, also slightly down from the 2.7% that was clocked at the beginning of the year. Inflation in the service sectors of the euro economy was increasing in May at an annualized rate of 3.5%, to be compared with 3.9% in the beginning of the year.
So overall, there is no denying that positive news is coming from the inflation front with the overall inflation rate now narrowly below the 2% medium term target. However, core and especially service inflation are still running above that 2% target. The fact that the ECB’s macroeconomic models allow president Lagarde to argue that the ECB is on track to reach the 2% target “on a sustainable basis” should be taken with a pinch of salt. These models have in terms of inflation forecasting performed below par in the past. And that is a polite judgement on the performance of those models.
“That the ECB is on track to reach the 2% target “on a sustainable basis” should be taken with a pinch of salt”
It can be argued that lower oil and energy prices and the stronger euro have not yet fully fed through to the inflation numbers. A weakening of economic growth, not to speak about a possible recession, will also tend to reduce price pressures. Some further relaxation in overall inflation pressure is hence quite possible but forces working in the other direction should not be underestimated. First, wage increases remain strong and clearly above inflation. Wages in the eurozone edged up by 4.5% in 2024, the highest annual increase since 1993. For 2025 wages are expected to grow by 3.6%, again substantially above expected inflation and even more so above increases in productivity.
Second, the unavoidably upward price consequences of the tariff escalation that is still very much in the air will obviously push up inflation. Trump’s tariff crusade has injected an intense drive to reschedule international supply chains in order to minimize the pain of trade wars. This rescheduling is generally expected to raise prices across a broad range of products and services. The next batches of inflation data will gradually reveal where all this is going. But we can rest assured: uncertainty surrounding inflation and growth will not diminish, on the contrary. Given such uncertain and volatile perspectives, a somewhat more cautious monetary policy might be called for.
Given all the above it seems to be an entirely legitimate question to ask whether the ECB has not been running too fast on the downward policy rate track. Real policy interest rates (the nominal policy interest rates minus the inflation rate) are now basically zero in terms of the overall inflation rate but negative when compared to the core inflation rate and deeply negative when set against the ongoing service sector inflation rate. The service sector is in modern economies like the eurozone’s one good for something between 65% and 75% of GDP. Negative real interest rates erode the purchasing power of most savings (and of money in general), tend to reward speculative financial behavior and increases the likelihood of a renewed outburst of inflation.
“It seems to be an entirely legitimate question to ask whether the ECB has not been running too fast on the downward policy rate track”
It is quite interesting to compare the ECB’s recent rate cycle with the one followed by the American central bank (the Fed). Also challenged by rapidly rising inflation, the Fed pushed up its principal policy rate, the federal funds rate, from 0.25% in early 2022 to 5.5% in July 2023 and kept it there till August 2024. In line with the ECB, the Fed started to cut rates till December 2024 arriving at a 4.25 – 4.50% range for the federal fund rate. Contrary to the ECB the Fed stopped there.
With an overall inflation rate most recently at an annualized rate of 2.3%, the core inflation rate at 2.8% and the service sector inflation rate at 3.7%, policy interest rates in the United States are deep into positive territory. Given the continued strength of the American economy (although recent data rather go the other way), the continued relative tightness of its labor markets and the inflationary threat of Trump’s tariff extravaganza, there are good reasons to keep American real interest policy rates substantially above zero. It is quite remarkable that Fed chairman Jay Powell and his rate setting committee persist in this policy despite the open attacks on that policy by president Donald Trump.
Unspoken
My conclusion at this point is that the Fed’s case to keep real interest rates positive is (much) stronger than the ECB’s case to push real policy rates to zero and even below zero. The argument that this is needed to support the ailing growth in the eurozone and to reduce uncertainty driven up by Trump’s erratic and counterproductive policy initiatives is really not convincing. Does with respect to these concerns a 2% nominal policy rate make much difference with a, say, 2.5% nominal policy rate? To answer yes on this question is to manifestly overstate the importance of monetary policy with respect to growth and uncertainty and underestimate the importance of monetary policy in the medium term fight against inflation. It is moreover neglecting the by now well-documented unintended consequences of too low interest rates.
Why then has the ECB pushed policy interest rates down to their present levels? I see three reasons un-spoken off by ECB decision-makers. First, lower euro interest rates should help to stop the upward movement of the euro, especially versus the dollar, still the dominant currency in world economic affairs. Since the election of Donald Trump the euro has gained 10% in value against the dollar (from roughly 1.05 dollars to the euro to 1.15 dollars to the euro). This revaluation of the euro is a heavy burden on the export potential and the profitability of eurozone companies.
Second, the higher the interest rate the more pressure there is in the economy to de-leverage, i.e. to reduce positions of heavy borrowing. Quick and intense deleveraging causes however significant downward pressure on asset prices ravaging balance sheets of companies and financial institutions and hence increasing financial stability risks. Lower interest rates reduce de-leveraging pressure. Thirdly, many eurozone governments, not least France and Italy, the numbers two and three of the eurozone economy, are facing substantial budget deficits and mounting debt burdens. Higher interest rates aggravate these awkward fiscal positions again augmenting financial stability risks. Lower interest rates bring breathing space. At least in the shorter run.
“ The more signals governments receive that central bankers are coming to the rescue, the weaker the incentives become to put public finances in order and to push through the much-needed structural reforms”
As far as the euro-dollar exchange rate is concerned the ECB is understandably silent about this since it might ignite a discussion on the ECB’s mandate. As to the two other considerations – deleveraging and public finances – the question is whether the ECB is not worsening long-term perspectives while trying to realize uncertain short-term benefits. The more signals governments receive that central bankers are coming to the rescue, the weaker the incentives become to put public finances in order and to push through the much-needed structural reforms.
Humility
Let me conclude by a note of humility. First, there is no denying that deciding on monetary policy in the present environment is utterly demanding. The degree of geopolitical, economic and financial uncertainty is simply mind-boggling with no clear signals of abating tensions. So anyone formulating criticism on the path taken by a central bank like the ECB should be well aware that nobody has a crystal ball. A lot of policy balls and related parameters are up in the air. I am fully aware of this reality and the reader of this blog should bear this in mind too when reading my comments.
Secondly, my critical comments should not and cannot lead to assigning me the conviction that the independence of the ECB has gone too far and should be challenged. No, no way. A central bank under the direct tutelage of the political world will bring us in the worst of all situations since the political world can seldom resist the temptation to drown its problems in a sea of money creation. History abundantly shows us that such an evolution always ends in tears, if not worse.
Johan Van Overtveldt 