The European Central Bank is expected to deliver the fourth rate cut of this cycle on Thursday, along with fresh staff economic projections. As a result, the deposit facility rate will be cut by 25bps from 3.25% to 3.0%. The key question is what happens next in the new year, and whether there is a change of guidance of policy restrictiveness. Currently, markets give an 85% chance of another 25bps move, with a 15% chance of a jumbo-sized 50bps cut. Investors then expect five more quarter-point cuts next year, that will bring the deposit rate to 1.75%.

Expectations are for a discussion on the merits of a deeper cut given growth risks have been pointing to the downside. It seems the ECB has moved on in recent months from concerns over inflation to growth dynamics. That means policymakers may want to find a way to express the chance that rates can be cut until a neutral level is reached.

Markets will be watching the statement for any material changes around this. Many observers predict the bank may abandon its mantra that monetary policy will remain “sufficiently restrictive for as long as necessary” to achieve price stability. Following the disinflationary process that has gained traction through 2024, the updated staff projections are likely to forecast inflation hitting the ECB’s 2% target from 2025 and onwards. So, whether monetary policy should stay restrictive is likely going to be debated, with the two opposing hawkish and dovish camps battling it out.

Recent data

Since the October meeting, the momentum in underlying inflation has fallen further and growth indicators have weakened. Survey data showed a marked drop in the November Eurozone Composite PMI to 48.1 from 50.0, with heavy pessimism surrounding the French economy. Not only is the region’s manufacturing sector sinking deeper into recession, but the services sector is now starting to struggle after two months of marginal growth. Indeed, the region’s two biggest economies, Germany and France, are wracked by political uncertainty and likely to contract in Q4. On the inflation front, the headline has increased from a three-year low, mainly due to base effects. But the monthly increase in core inflation is well in line with 2% annualised inflation. Crucially, this has been driven by services inflation where momentum is also quickly nearing the 2% target.

Market reaction

Post-decision communication will be the main driver of volatility in markets. A dovish 25bp cut, in which the ECB signals it is open to bigger size moves, could see some euro selling. That said, some of this may already be priced in. If the bank sticks to quarter-point increments, there could be a modest euro rally, though this may be caveated with a meeting-by-meeting approach.