Choppy markets threaten ECB’s ‘good place’ but rates still firmly on hold

[FRANKFURT] The European Central Bank (ECB) is all but certain to keep interest rates unchanged on Thursday (Feb 5) and signal that no policy move is imminent, even if the euro’s recent surge against the US dollar fuels concerns that inflation might undershoot its target.

The euro zone’s central bank has been on hold since ending a year-long run of rate cuts in June, and a benign outlook for both growth and prices has taken nearly all pressure off policymakers to provide any further support.

With inflation at the 2 per cent target, growth steady at the currency bloc’s potential and interest rates on a neutral setting, some have called the current period a central banker’s nirvana or the ECB’s “Goldilocks” moment.

Messy environment threatens “good place”

That is why ECB President Christine Lagarde is likely to repeat her mantra that policy is in a “good place”, with no debate over changing borrowing costs likely in the near term.

But last week’s tumble in the US dollar, volatility in commodity markets, the Trump administration’s war of words over Greenland and its pressure on the US Federal Reserve to cut rates, are all reminders that the situation could quickly change.

“It has been a tumultuous start to the year in terms of geopolitics and there have been some significant market moves,” JPMorgan economist Greg Fuzesi said.

Thursday’s meeting is the first since Bulgaria joined the bloc on Jan 1, taking the number of countries that share the euro currency to 21.

Dollar’s fall not a problem yet

A strong euro relative to the US dollar and other currencies lowers import costs, especially for energy, and curbs inflation at a time when it is already undershooting the ECB’s target.

Inflation, the ECB’s primary focus, slipped to 1.7 per cent across the euro zone last month and could dip further before a forecast rebound next year, stirring memories of the ECB’s struggle to rekindle price growth for the decade before the Covid-19 pandemic.

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But the move in the currency is not a deal-breaker for now.

“The recent jump in oil prices, if sustained, should offset much of the disinflation impact from a stronger euro, reducing the urgency for the ECB to adjust policy,” Societe Generale’s Anatoli Annenkov said.

“But over the medium term, higher oil prices combined with a stronger currency could sharpen concerns about competitiveness and growth, increasing pressure for monetary support,” Annenkov added.

On a trade-weighted basis, the euro has moved little this year, reinforcing market expectations for no interest rate changes in 2026.

If anything, longer-term inflation expectations have been inching up, not down.

Europe has a competitiveness problem

For now, Lagarde is likely to repeat that the ECB has no exchange rate target and that the euro’s strength is merely one factor that impacts inflation.

She can also point to healthy economic growth figures, historically low unemployment and solid wage growth data to support a sanguine tone.

The euro zone has proven surprisingly resilient to trade strife as domestic consumption seems to be taking up the slack created by weak exports and poor industrial production.

Given exceptionally high domestic savings and a strong labour market, economists expect consumption to keep the bloc growing, with the German government’s planned fiscal splurge on defence and infrastructure a further push to expansion.

“The path of monetary policy in 2026 will depend on who wins the contest between external conditions and internal conditions,” Deutsche Bank said in an analysis. “Our baseline assumes that domestic resilience will dominate and that leads to (interest rate) hikes in 2027.”

Risks could still go the other way, however, and if inflation is below target long enough to drag expectations below 2 per cent, policymakers may have no choice but to provide more support. REUTERS