ECB sees no imported inflation threat as it prepares further rate cuts

The European Central Bank sees no serious threat of inflation crossing the Atlantic from the United States and will press ahead with a gradual sequence of interest-rate cuts that could bring the deposit facility to 2% by September, President Christine Lagarde said in an interview with CNBC on Wednesday.

The remarks, made at the World Economic Forum in Davos, mark the clearest signal yet that the ECB intends to decouple its easing cycle from the Federal Reserve's more cautious trajectory. Markets currently price a full percentage point of further ECB reductions by autumn, against barely half a point for the Fed, a gap Lagarde attributed to fundamentally different economic conditions on either side of the ocean.

Lagarde's calm rests on the ECB's baseline forecast that euro-area inflation will settle at the 2% target over the course of 2025. The December flash estimate from Eurostat put annual price growth at 2.4%, the third straight monthly rise after a trough of 1.7% in September. That rebound was expected: base effects from energy prices and the phasing-out of government support measures were always likely to push the headline figure up temporarily.

The central bank's December staff projections see inflation averaging 2.1% this year, barely above target. Lagarde stressed that the disinflation process remains intact and that policymakers will watch services, energy, wages and "late-comer" items such as insurance premiums for confirmation that service-price momentum eases in early 2025.

The ECB cut its deposit rate four times in 2024, taking it to 3%. The Federal Reserve, by contrast, delivered only one reduction in the second half of the year. Lagarde noted that "markets anticipate vastly different monetary policy moves in the next few months" and that the two central banks "did not reduce rates at the same pace" last year. The divergence, she said, "has to do with a different economic setting at the moment between the U.S. and Europe."

That setting is visible in growth. The United States expanded at an annualised rate above 2% in the second half of 2024, buoyed by fiscal stimulus and resilient consumption. The euro area, by contrast, stagnated. Germany, the bloc's largest economy, recorded its second consecutive annual GDP contraction in 2024, a fact Lagarde acknowledged by describing risks to growth as "to the downside."

The German economy shrank by 0.2% in 2024 after a 0.3% decline in 2023, according to Destatis. High energy costs, weak Chinese demand for capital goods, and the lagged impact of earlier rate hikes have combined to keep manufacturing in recession. The ECB's governing council has long argued that monetary policy works with a lag of 12 to 18 months, meaning the full drag of the 4.5 percentage points of tightening delivered between July 2022 and September 2023 is still feeding through.

Lagarde's language on growth was notably cautious. She did not repeat the "soft landing" formulation used in earlier press conferences, instead flagging downside risks. That phrasing matters: it keeps the door open for a faster cutting pace if incoming data disappoint, even as the baseline remains gradual.

While goods inflation has turned negative in several months and energy has been volatile, services prices have barely budged. The annual rate has hovered close to 4% since November 2023, driven by wage growth that has outpaced productivity and by the delayed pass-through of earlier cost shocks in sectors such as hospitality, transport and insurance.

Lagarde singled out insurance as a "late-comer" factor that could keep services inflation elevated in the first quarter. The ECB will examine whether the expected gradual reduction in service-price momentum materialises in the January and February data. If it does not, the case for a pause in April or June strengthens, regardless of the Fed.

Lagarde also updated her estimate of the neutral real interest rate, the level that neither stimulates nor restricts the economy, to a range of 1.75% to 2.25%, down from 1.75% to 2.5% in December. With the deposit facility at 3% and inflation at 2.4%, the ex-post real rate is currently around 0.6%. Even at a 2% nominal rate, the real rate would be slightly negative if inflation hits target, implying policy would remain mildly accommodative.

The narrowing of the neutral range reflects the governing council's growing confidence that the terminal rate for this cycle is lower than previously thought. It also signals that the ECB does not intend to cut deeply into restrictive territory unless growth deteriorates sharply.

Lagarde acknowledged one channel through which US inflation could affect Europe: the exchange rate. "The exchange rate, for instance, will be of interest, and ... may have consequences," she said. A weaker euro, driven by wider rate differentials, would raise import prices and could slow the disinflation process. The trade-weighted euro has fallen roughly 3% since the Fed signalled a slower cutting path in December.

The ECB does not target the exchange rate, but it monitors the pass-through to import prices closely. So far, the effect has been muted because commodity prices, denominated in dollars, have not surged. That could change if US tariff policies shift under the new administration, a risk Lagarde did not address directly but which several governing council members have raised in recent speeches.

The next governing council meeting is on 30 January. No change is expected; the focus will be on the March meeting, when new staff projections arrive. Between now and then, the flash January inflation estimate (31 January), the February composite PMI (21 February) and the negotiated wage growth data for the fourth quarter (early March) will shape the debate.

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With inflation at 1.7% and the euro up 14% in a year, the central bank faces competing pressures that could force a shift sooner than markets expect.

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