ECB cuts its policy rate as expected, and probably not for the last time
ECB cuts its deposit rate to 2.25%
A no-brainer. At its policy meeting on 17 April 2025, the ECB cut its deposit rate by 25 basis points to 2.25%, as expected. Its main refinancing rate and marginal lending rate thereby fell automatically to 2.40% and 2.65%, respectively.
The decision is in line with our scenario. Since the market had also largely priced in the rate cut, German 10 year yields only reacted moderately and decreased by about 5 basis points to just below 2.50%.
For the ECB, its policy rate is now in the neutral zone. It made this clear by removing the earlier reference to the restrictive nature of its policy from the press release.
ECB president Lagarde justified this decision with the deteriorating growth outlook for the eurozone due to trade conflicts, as well as low and further declining financial market inflation expectations for the year ahead. Thus, unlike the policy dilemma for the Fed (higher inflation expectations and lower growth expectations), the policy choice for the ECB, more specifically the rate cut, was unambiguously obvious.
Given the extreme degree of uncertainty, particularly of (US) trade policy and the impact on European growth and inflation, the ECB stresses that its further policy remains data-dependent and that policy decisions are made from meeting to meeting, without any pre-commitment.
Economic uncertainty also leaves its mark on the Bank Lending Survey
High uncertainty also weighed on the results of the ECB's latest 'Bank Lending Survey' (BLS) for the first quarter of 2025. That survey gauges the development of bank lending in the eurozone.
High uncertainty was a key reason for the (albeit limited) further tightening of credit conditions for businesses and consumers in the first quarter. Only for housing loans did conditions ease slightly. For the second quarter, surveyed banks expected further tightening of conditions for all three credit segments.
On the demand side of loans, the BLS again reported a slight net decline from corporates, as a result of a negative contribution of inventories and working capital of businesses. This may again partly reflect economic uncertainty. In contrast, net demand for consumer and housing loans still rose slightly for the time being due to lower interest rates and somewhat improved consumer confidence.
Finally, the passive reduction of the ECB's monetary policy portfolio, as a result of not reinvesting maturing assets, had a slightly negative impact on euro area banks' market funding conditions and liquidity positions over the past six months, according to the BLS. In other words, this is due to related decrease of excess reserves (relative to minimum requirements). The ECB's passive balance sheet reduction also increased banks' holdings of euro area government bonds for the first time since the launch of the government bond purchase programme (the so-called PSPP) in early 2015. This trend is likely to continue over the next six months, according to the BLS. However, the impact on credit conditions is expected to remain limited, as the unwinding of the ECB's monetary policy portfolio proceeds at a measured and predictable pace.
Intra-EMU interest rate spreads widen by a handful of basis points
The ECB's passive reduction of excess liquidity in the market may also have been a determining factor behind the recent moderate rise in intra-EMU spreads on government bond yields, in addition to decreased global risk appetite. Nevertheless, we confirm the scenario of KBC Economics that spreads have little upside potential and will again decline moderately. In this context, the option for the ECB to activate its Transmission Protection Instrument (TPI) if necessary continues to play its role of 'safety net' for the further spread evolution.
End of interest rate cycle in sight, but not yet reached
From the ECB's point of view, both the growth and inflation forecasts for the next twelve months point towards (at least) one further rate cut. According to KBC Economics, the sharply lower market inflation forecast for the next twelve months (partly caused by the strong euro exchange rate) gives the ECB sufficient policy space to cut interest rates by another 25 basis points to 2% in June. We expect this to be the bottom for the deposit rate in this interest rate cycle, roughly in line with the neutral level.
However, given the extreme uncertainty, there is a downside risk to the policy rate. The market is currently pricing in a floor for the deposit rate of 1.75%, as it implicitly fears that the negative growth impact of the trade tariffs for the eurozone will turn out to be larger than expected and/or that the sharply lowered inflation expectation for the next twelve months will persist or even fall further. In other words, the market seems to expect that the EU will not take meaningful countermeasures against US import tariffs and will also respond with little or no anti-dumping duties on Chinese exports diverted from the US to the EU.
For KBC Economics, this market scenario for policy rates looks too strong for now. After all, we assume that there will be a (albeit moderate) policy response from the EU. Thus, the market's pronounced low inflation expectations for the short-term may be somewhat exaggerated. Also for the growth outlook, while we are very cautious, we are not so pessimistic that the ECB should cut its policy rate to well below 2%. That would only be plausible in case of a full escalation of the trade conflict. Of course, this is not ruled out, but until further notice this remains a downside risk scenario (albeit a material one).