ECB Remains Attentive and Focused

The European Central Bank (ECB) left its policy rate unchanged at 4% in December. As interest rates have presumably reached peak level, the focus has shifted towards when the ECB might start to cut. While recent inflation developments have been encouraging, the market is now fully pricing swift disinflation back to the central bank target, with the first rate cut around March next year.

Although economic momentum in the euro area remains weak and recent inflation prints surprised to the downside, labour markets remain in good shape and the medium-term inflation trajectory uncertain. Underlying inflation is still at 3.6%, well above the 2% headline target. For inflation to evolve in line with ECB projections, growth in unit labour costs needs to falls back to levels consistent with 2% inflation, and firms need to use their profit margins as a buffer to limit the pass-through of the current strong wage increases to consumer prices. More clarity is needed for the ECB to change course.

While the new staff macroeconomic projections include the inaugural estimates for 2026, the ECB has made clear that it aims to achieve its inflation target no later than in 2025. Overall, activity and inflation data have been softening since the last projection round in September, so there have been downward revisions in December. For headline inflation, the projections show the harmonised index of consumer prices (HICP) in 2024 revised down to 2.7%, unchanged at 2.1% in 2025, and at 1.9% from Q1 2026 onwards. President Lagarde stressed that financial conditions are currently easier than embedded in the projections.