How much further will European Central Bank cut interest rates?

14/07/2025 04:21 AST

Spiralling inflation in the Euro Area was finally stabilized last year after an unprecedented cycle of policy rate increases by the European Central Bank (ECB).

The most aggressive tightening sequence in the history of the ECB took the benchmark interest rate to 4%, as a response to the unprecedented post-Covid inflationary shock.

This was followed by a "holding" period of nine months, as the central bank waited for inflation to shorten the gap between the peak of almost 11% and the 2% target of monetary policy, QNB said in its economic commentary.

Interest rate cuts finally began in June last year at a cautious pace, as ECB officials gained confidence in diminishing price pressures.

This brought the deposit rate to 2%, a level broadly within the "neutral range" that implies that monetary policy is neither expansionary nor contractionary.

With inflation recently oscillating narrowly around the 2% mark, the ECB must now calibrate the appropriate terminal rate.

In our view, the macroeconomic outlook warrantstwo additional rate cuts this year.

In this article, we discuss three key factors behind our analysis.

First, there is an increasing likelihood that inflation will meaningfullyundershoot the 2% target of the ECB.

The latest release of consumer prices displayed a headline inflation rate of 1.9% in May, before hitting the 2% target in June.

Additionally, reducedwage increases will further diminish price pressures in the labour-intensive services sector, which typically exhibitshighly persistent inflation.

More importantly, markets are signallingthatinflation will decrease in the year ahead.

Financial instruments can provide useful information regarding the expected evolution of macroeconomic variables.

Second, after lingering on the verge of a recessionfor the last two years, the Euro Area is set for another period of underwhelming growth performance.

The recent prints of the PurchasingManagers Index (PMI) point to a stagnant economicoutlook.

The PMI is a survey-based indicator thatprovides a measurement of improvement ordeterioration in the economic outlook.

The composite PMI, which tracks the joint evolution ofthe services and manufacturing sectors, has remainedbelow or close to the 50-point threshold thatseparates contraction and expansionsince August last year.

The conditions for the manufacturing sector are particularly negative, with the PMI for industryhaving stayed in the contraction range for the last three years, amid the region's energy crisis, geopolitical uncertainty, and escalating global trade conflicts.

Third, credit growth in the Euro Area remains lacklustre.

In spite of the significant interest rate cutting cycle implemented by the ECB, long-term interest rates have not shown a major reduction.

The 10-year euro-bond rate remains above 3%, and largely unmoved in the last two years. Long-term interest rates are key for the economy, given their influence on business investment and household demand.

All in all, in spite of erratic short-term price pressures and tariff-wars alarms, we believe the balance of risks continues to lean more heavily on weak growth performance over inflation concerns.

With this outlook, the ECB could implement two additional 25 b.p. cuts this year, taking the deposit interest rate to 1.5%.

The Peninsula