Fuxing Bank looks ahead to European Central Bank policy: A further 25 basis point rate cut in March, when will they hit the "pause button" next?

Recently, the French Industrial Bank released a research report on the outlook of the European Central Bank's policy, predicting a further 25 basis point cut at this week's policy meeting. The report also stated that core inflation still poses risks and highlighted the importance of the outcome of public sector wage negotiations in Germany. The bank believes that after the rate cut in April, a better evaluation of the medium-term outlook and risks may occur in June, possibly leading to quarterly rate assessments. At this week's ECB meeting, another 25 basis point rate cut is expected, along with the removal of restrictive statements regarding policy stance. If these statements are retained, it would indicate that the committee members foresee further rate cuts at the next meeting in April. While this aligns with the French Industrial Bank's forecast, the bank questions whether the current data is clear enough to signal this and suggests a focus on upcoming data releases. Discussion on the neutral rate has begun, with ECB Executive Board member and economist Isabel Schnabel emphasizing the upward pressure facing the natural rate (r*) in a recent speech. She advocates caution in easing policy and emphasizes the importance of newly released data. She also notes that it is no longer certain that the ECB's policy is restrictive. However, given the high uncertainty around the neutral rate, many committee members may still lean towards further rate cuts into a lower range, especially when this uncertainty poses risks to the economic outlook. Despite significant uncertainties in the US, the French Industrial Bank still sees sticky inflation risks and is closely monitoring the outcome of wage negotiations in the German public sector. The bank believes that after another rate cut in April, the ECB could better assess the medium-term economic outlook and risks in June, potentially shifting to quarterly rate assessments. New staff forecasts may indicate slightly higher inflation rates this year, while GDP growth in the Eurozone may slightly decrease. The bank's forecast for ECB policy includes quantitative tightening reaching around 500 billion monthly in the first quarter of 2025; a 25 basis point rate cut in March 2025; a further 25 basis point rate cut in April 2025, bringing the rate down to 2.25%; and the launch of structural long-term credit operations in the second half of 2026. Despite data slightly outperforming expectations, uncertainty remains high. While concerns have been raised about a substantial slowdown in the European economy due to US tariffs and elevated uncertainty, the French Industrial Bank believes that the confidence impact of US trade policies may have eased. Global trade recovery has countered the downward trend in manufacturing, offsetting negative confidence effects. Therefore, the bank notes that substantial weakness in the labor market is not yet evident, and such weakness may be necessary to bring wage growth from above 4% to a level conducive to price stability, which could be significantly lower than 3% if productivity remains low. One key wage agreement to watch is the wage agreement in the German public sector, with negotiations currently underway. The current demands include an 8% wage increase within a year, with the next round of negotiations starting on March 14. While downside risks to economic growth and inflation remaining below target may still dominate the thoughts of many policymakers, more data on potential risks to core inflation may be needed. New staff forecasts are expected to show a slowdown in economic growth, but inflation presents two-way risks. Before a significant change in ECB forecasts occurs, the bank expects forecasts not to change much. Higher energy prices than expected could lead to a slight increase in overall inflation rate this year, while GDP growth this year and next may slow down. The bank still expects overall inflation in Europe to be lower than the ECB's current projections next year, mainly due to stronger assumptions about exchange rates. The bank forecasts higher core inflation in 2026 than the ECB's forecast, as despite similar forecasts for unit labor costs, the bank is less optimistic about the European labor market and profit situation being able to bring core inflation down to around 2%. Due to a significantly widened risk distribution, the bank believes that early changes in the outlook for policy rates will not occur until June. While the economy has weathered recent uncertainty well, clearer developments on tariffs, the Ukraine situation, and conditions in Germany and France by June may lead to more significant forecast changes. If by then domestic demand and the labor market show resilience as expected by the bank, the ECB may pause rate cuts, although there is still room for further cuts within the neutral rate range. Moreover, discussions on the neutral rate have begun. The bank sees the ECB's still significant balance sheet as a reason to proceed cautiously with rate cuts. Isabel Schnabel believes that the real equilibrium rate r is facing upward pressure, and loose policy should be cautious. Over the past decade, regulators have increased liquidity requirements, central banks have implemented quantitative easing policies, governments have tightened fiscal policies, and investors have been willing to pay a premium for holding these safe assets, lowering the real equilibrium rate. Now, this trend is reversing, with large government net borrowing, balance sheets moving towards normalization (quantitative tightening), geopolitical divisions weakening demand for safe assets, and global savings surplus transforming into a global bond surplus. Thus, the upward pressure on the natural rate (r*) may persist for some time. This will provide lessons for future quantitative easing policies, which should be more temporary and targeted, potentially impacting the ECB's strategic review later this year.