Euro area: Potential fiscal boost adds (even more) uncertainty around rates

The economist view – Melanie Baker, Senior Economist

With fiscal policy in flux, an uncertain global backdrop, and with interest rates having been cut so far already, the impression from European Central Bank (ECB) President Christine Lagarde was of an even less certain path ahead for interest rates, albeit steering away from the chance of rate hikes.

On the surface of the ECB policy decision and communications, not much changed: the 25bps rate cut today (to 2.50% on the deposit rate) was very much as expected. They continue to describe the disinflation process as well on track; They continue to “follow a data-dependent and meeting-by-meeting approach” without pre-committing to a particular path; They still see the skew of risks to growth as to the downside. However, even in the statement there were a couple of changes of note. One was the statement that “monetary policy is becoming meaningfully less restrictive”. The second was to add the phrase “especially in current conditions of rising uncertainty” to the familiar statement that they will follow “data dependent and meeting-by meeting approach”. Uncertainty was a recurring theme for the press conference.

Lagarde was clear that, should additional defence/infrastructure spending mooted in Germany come through, that would be a positive for aggregate demand. However, she also pointed to significant uncertainties and the importance of the detail.

ECB staff revised down their forecasts for euro area growth, but Lagarde admitted that staff had not had the chance to incorporate any effects of increased fiscal stimulus. She was clear that, should the additional defence spending/infrastructure spending mooted in Germany and being discussed at a broader European level, come through, that would be a positive for aggregate demand. However, she also pointed to significant uncertainties and the importance of the detail.

It makes sense for the ECB to be pretty circumspect about all this at this point in time. German fiscal changes have not been agreed/approved and it is unclear at this point in time what flexibility for extra spending will be agreed at EU level. It is not clear how all this will be financed. We don’t know the timing of flows either, which will be important in terms of the growth and inflation impact. Some of the increase in defence and infrastructure spending will presumably ‘leak’ from the euro area in the form of imports. The context is also important – all this is occurring against the backdrop of developments in global trade/politics/tariffs that look set to drag on global growth, both through the direct effects of tariffs and by increasing uncertainty. Recall that US President Donald Trump has repeatedly promised significant tariffs against the EU.

On inflation, Lagarde pointed to two-sided risks from tariffs and in the opening statement flagged that a boost in infrastructure and defence spending could raise inflation (through the impact on demand). It will ultimately be the inflation impact/forecast inflation impact that they will react to. For now, staff inflation forecasts remain consistent with them hitting their 2% target sustainably in the next year. Amid all the uncertainty, Lagarde pointed to some things that were more comforting on inflation, saying for example that wage growth was moderating as expected.

When asked about what recent developments meant for monetary policy, and against that backdrop of monetary policy already being much less restrictive, Lagarde repeated variations on the same theme. She said that 1) disinflation remains on track; (but) 2) that monetary policy is meaningfully less restrictive and 3) that they are facing huge uncertainty. She talked about them wanting to reach their destination (i.e. hit the 2% inflation target on a sustainable basis) but that not pre-committing to a particular path was even more relevant given current uncertainty. She did steer away from any expectation of a rate hike though, saying that the data could justify a cut or, if that was not the case, it would be a pause (while also saying they needed to be ‘vigilant’ and ‘agile’).

For my forecasts on euro area uncertainty in rates paths: the fiscal news, should it result in genuine and significant extra fiscal stimulus (as seems likely at the moment), could raise the euro area growth outlook by a few tenths of a percentage point. It makes it much more likely that the ECB doesn’t cut rates as far as the 1.75% I had pencilled in (which is closer to the lower end of some other estimates of neutral), despite the trade backdrop, and stop at 2%. In coming weeks and months, fiscal and trade developments will need close monitoring – as will the net impact of those things on financial conditions. These could easily knock any central forecast off track. While recent news has been growth positive for the euro area, we may not have to wait long before tariff announcements challenge the narrative again. 

The fund manager view – Gareth Hill, Senior Fund Manager, Rates & Cash

The backdrop for the March meeting of the ECB’s Governing Council could scarcely have been more turbulent; in a week where the EU announced an €800m defence package following the withdrawal of support from the US for the conflict in the Ukraine,  the German government proposing its own €500bn stimulus program across infrastructure projects and exemption for defence spending above 1% of GDP and European government bond yields rising by  around 50bps (0.50%), with much of this move occurred in the preceding two days. Market talk was of a sea-change in the European fiscal landscape, with Germany effectively abandoning its own self-imposed fiscal controls, referred to as the debt brake.

Market talk was of a sea-change in the European fiscal landscape

Prior to this week, there was already heightened uncertainty in markets, as a result of the potential tariffs to be imposed by the US, and any reciprocal action from those whom these tariffs were imposed upon. Notwithstanding this, the ECB was fully expected to continue with its interest rate cutting cycle for the sixth consecutive meeting, with a 25bps rate cut bringing cumulative easing to 150bps (1.50%) in this cycle. The market was not concerned about this but, rather, what would the ECB make of the shift higher in yields, the potential impact on growth of this fiscal impulse and how they could expect monetary policy to be adjusted going forward. So focus was not on the actions of this meeting (where the ECB duly delivered the expected cut), but on what ECB President Lagarde would have to say in the press conference following the decision. Unlike the meeting in January this year, the decision to cut interest rate this time was not unanimous; there was no opposition to the decision to cut, but there was one abstention from Austrian Central Bank Governor, Robert Holzmann, a known hawk.

In the press conference, the overriding watchword was “uncertainty”; indeed at one point reference was made to “phenomenal uncertainty”. There was an emphasis on further increased data dependency on future meetings, with decisions still being made on a meeting-by-meeting basis – so nothing has really changed in that regard. Disinflation is well underway and monetary policy is now meaningfully less restrictive, but this heightened uncertainty has made the path of future monetary policy less clear. However, when Lagarde expanded on this, it was clear that the decision was whether they keep cutting or whether they pause, as a result of the incoming data. No mention was made of hiking interest rates. On the issue of country spreads, Lagarde noted that despite the rise in yields, they had remained stable, so no need for further comment, let alone intervention.

In some regards, the proximity to meeting to the fiscal announcements may have helped; nothing has changed yet, nothing has been passed yet, and so there was no data upon which to form a revised view, yet. Reference was made to the situation changing “from 1 day to the other”, and the obsession in the previous meeting on where the neutral rate of interest, R*,  was long forgotten. Focus now is on uncertainty and increased data dependency. Whether the ECB cuts again in six weeks time in their next scheduled meeting remain to be seen – the devil will be in the data!

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