This year has begun with turbulent geopolitical conditions in Europe, yet the European Central Bank is likely to keep its focus on the big picture rather than the details. This suggests it may not pay excessive attention to recent US-EU trade disputes related to Greenland, inflation rates slightly below the 2% target, or the appreciation of the euro.
However, recent developments highlight that downside risks to the economic outlook are accumulating. Even so, following its February 4-5 meeting, the ECB is unlikely to add fuel to the fire with hawkish rhetoric.
The economic impact of US President Trump's threats to impose tariffs on some European countries is likely to be limited. Our EU Trade Policy Uncertainty Index has already retraced about half of its gains from January.
In December, the Eurozone's headline HICP inflation rate slowed to 1.9% from 2.1% in November. It is projected to fall another 0.1 percentage points in January.
On a trade-weighted basis, the euro is currently about 7% higher than the average level of the first quarter of 2025. Any further appreciation would amplify the downside risks to the interest rate outlook.
Our internal central bank sentiment model, the ECBspeak Index, remains near neutral levels, indicating that the Governing Council is likely to keep interest rates unchanged for the foreseeable future.
"As central bank decision-makers and economists, our job is to distinguish between signals and noise," ECB President Christine Lagarde stated at the Davos forum on January 23. Since the last meeting on December 18, markets have been filled with a lot of noise but few new signals. While Trump expressed a stronger willingness to annex Greenland, he has since retracted threats of using military force and imposing additional tariffs on European countries opposing his plans.
These threats initially caused our Trade Policy Uncertainty Index to spike, but it has since fallen significantly. The Eurozone Composite PMI survey indicates that despite the threat of US tariffs, the Eurozone economy has remained stable, suggesting the recent surge in uncertainty has had a limited economic impact. The survey period may not have fully captured this trend, but it likely reflects a substantial part of it.
The most significant development since the last meeting is probably the 0.2 percentage point drop in the December inflation rate. Data released on the day of the Governing Council's two-day meeting is expected to show a further slowdown in price growth of 0.1 percentage points, falling below the ECB's 2% target.
In December, ECB staff revised most of their inflation forecasts upwards, anticipating a slower decline in services inflation. A majority of the Governing Council is likely to use this as a reason to keep rates steady. While being 0.1 percentage points below the inflation target is not enough to trigger intense debate within the committee, a sustained period of inflation below 2% would make the policy narrative presented in December difficult to maintain.
We will focus on whether the risk assessment section of the post-meeting statement shows signs of increased concern about the inflation outlook. The language on threats to price stability in December was slightly hawkish, adding "slower moderation in wage pressures" as an upside risk factor.
At its last meeting of the previous year, the description of risks to GDP growth was largely consistent with the statement following the prior meeting. The only notable change was the mention that easing geopolitical tensions and resolved trade disputes could provide a boost to economic growth.
Since the trade shock in April of last year, the euro has surged approximately 14% against the US dollar, and has risen about 7% on an effective exchange rate basis—the most important gauge for inflation prospects. According to calculations from our Euro Area macroeconomic model, SHOK, a 7% appreciation in the euro's effective exchange rate since April 2025 could depress the Eurozone's overall inflation rate by about 0.2 percentage points in 2026, and by another 0.2 points in 2027.
However, a stronger euro is unlikely to panic the Governing Council. The impact of its appreciation has likely already been factored into the central bank economists' latest inflation projections, as the euro's effective exchange rate remains near levels seen at the December meeting.
Nonetheless, policymakers are unlikely to encourage further euro strength by signaling a hawkish stance. Instead, they may emphasize the currency's dampening effect on the economy to temper its appreciation.
Analysis from our internal model, which decomposes daily fluctuations in the EUR/USD exchange rate into key drivers, indicates that global risk appetite has supported the euro's strength. As mentioned earlier, risk appetite is expected to continue supporting the euro, presenting another downside risk to the inflation outlook.
Overall, the various commotions since the start of the year have had little impact on the ECB Governing Council's policy stance. Our ECBspeak index is virtually unchanged from its level at the time of the last meeting.
Nevertheless, we still believe the ECB is underestimating the threat of US tariffs to the Eurozone economy (as well as the risk that German fiscal stimulus may fall short of expectations). The impact of US tariff hikes on Eurozone inflation will materialize gradually, as the effects on external demand and the broader economic consequences take time to manifest. These effects are likely to become more apparent this year, and although we forecast policy rates will remain unchanged in 2026, the risks are tilted towards further monetary policy easing.
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