European Central Bank cuts rates as possible trade war looms

The European Central Bank has cut interest rates by another quarter of a percentage point, lowering credit costs for consumers and businesses to support an economy that is struggling to show solid growth.

The rate decision on Thursday, which was widely expected by economists, was overshadowed by concerns over a potential trade war with the US and the impact of a surge in defence spending, two factors that could upend expectations for growth and inflation.

The ECB’s rate-setting council lowered its benchmark deposit rate to 2.5%. That should provide support for growth by making it cheaper to borrow and buy a house or expand a factory.

The rate was raised to a record 4% to combat inflation that reached 10.6% in October 2022, but has been reducing it steadily since June.

As inflation has fallen to an annual 2.4% concern has shifted to weak growth prospects in the 20 countries that use the euro currency.

The eurozone showed zero growth in the last three months of 2024, and prospects for this year are muted amid uncertainty about US President Donald Trump’s trade policy.

President Christine Lagarde’s comments at a post-decision news conference will be scrutinised for hints about how far the bank will cut rates amid discussion on the so-called neutral rate where bank policy neither stimulates nor holds back the economy.

At its last meeting, the bank said rates were still in “restrictive” territory, indicating further cuts were ahead.

Meanwhile, new concerns that would massively reshuffle the economic picture are likely to intrude: the potential impact of new tariffs on European imports from Mr Trump, which could slow growth, and plans for massive new defence spending and borrowing, which could mean more growth but also more inflation.

Those two forces could push the ECB in opposite directions. A hit to growth would call for lower rates in months ahead, while more persistent inflation would argue for keeping rates higher in coming months.

Growth estimates for Germany, the eurozone’s largest economy, shot up overnight and long-term interest rates rose in response to an agreement by the two parties that will form the country’s next government to loosen constitutional limits on borrowing and exempt defence spending.

That is a major turnaround in German budget policy and opens the way for a trillion or more in new borrowing and spending over the next decade.

Also in the mix are concerns that Mr Trump will impose new tariffs on European goods, hurting growth in an export-dependent economy.

The 20 countries that use the euro currency and for which the ECB determines interest rate policy stagnated in the last three months of the year, showing zero growth.

Consumers hurt by an earlier outbreak of inflation remain cautious, while businesses have been unsettled by concerns about what Mr Trump may do.

Julien Lafargue, chief market strategist at Barclays Private Bank, predicted the ECB would stay flexible and decide based on incoming data: “The possible push, in terms of GDP growth, from higher government spending may be offset by the pull coming from US tariffs and the net effect is unclear.”

Economists at Deutsche Bank predict the ECB will cut rates to 1.5% by the end of the year: “Our assumption is the negatives of a trade war dominate the positives of defence spending in 2025.”