Guns, Butter and Interest Rates
- 03 March 2025 (7 min read)
The ECB is meeting this week under inauspicious stars, amid domestic softness and sustained uncertainty over the trade relationship with the US. Another 25-bps cut is the widely expected outcome, but the conversation in the Governing Council is getting more difficult as the “neutral rate” range is now within sight. We continue to think that the balance of risks is now so blatantly skewed to the downside that the ECB will have to “cross neutral” and bring its policy rate to 1.5% by year end, but the central bank’s forward guidance may become even softer.
With the risks of a US military withdrawal from Europe rising quickly, the EU must scale up defence spending. This will at the very least reduce the quantum of fiscal tightening which could have been expected, since there are limits to how much of that extra spending could be funded by spending cuts elsewhere or tax hikes given the populist push which many governments are facing. In principle, this should make the ECB more cautious in providing monetary accommodation, but the expectation of more defence spending is putting a floor to how low long-term interest rates could go. We think the central bank will have to take on board the net tightening in overall financial conditions when calibrating its policy stance, especially since the ongoing Quantitative Tightening is another source of “yield resilience”. Yet, even with an “understanding” ECB, some member states are hitting limits to their fiscal space. This is another reason for us to think that joint funding of Europe’s military effort is necessary.
While the US is a major source of disruption for Europe, domestic conditions over there could be souring faster than we thought. Consumer confidence is deteriorating, across almost all components: Americans are getting nervous about inflation, their job prospects and the financial market. The House’s budget resolution was a breakthrough for the Republicans last week, but we note that it would not cover all of D. Trump’s campaign pledges. A complicated fiscal conversation is looming in Washington DC as well.
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