The outlook for inflation and interest rates in 2025

At our meeting yesterday, my ECB Governing Council colleagues and I decided to lower our three policy rates by 25 basis points (or one quarter of a percent). This moves our Deposit Facility Rate to 2.75 per cent.

Euro area inflation reduced over the course of 2024, reaching 2.4 per cent in December. 

Over the past year, the Governing Council has grown in confidence that there would be a gradual convergence of inflation to our 2 per cent target during 2025. However, the disinflation process remains subject to risks, and there is a high degree of uncertainty surrounding the outlook. We must stand ready to react to changes in the outlook, for both inflation and growth, which is why my colleagues and I continue to believe that we should not commit to any specific future path for interest rates.

Assessing our monetary policy stance

One source of uncertainty for policymakers is the interest rate at which our monetary policy stance is “neutral”.

A neutral rate provides us with a benchmark against which we can judge the stance. When our policy rate is higher than the neutral rate, we have a “restrictive” stance (in other words, we are seeking to dampen aggregate demand pressures in the economy) and we have an “accommodative” stance when the policy rate is below neutral (in this case, we aim to support demand).

As monetary policymakers, we choose to have a restrictive stance when our goal is to reduce inflation to our target, and to have an accommodative stance when we need to raise inflation to the target.

The neutral rate can be a useful guide for policymakers, but its usefulness is also limited. As I have highlighted before, it has a wide range of plausible values and it can change over time. So our policy decisions are guided by a comprehensive analysis of a wide range of economic data which is essential to ensure consistency between our view of the implied stance and economic developments. It is also why we need to continue with our data-dependent and meeting-by-meeting approach.

The recent high inflation period required a forceful response to ensure inflation would return to target in a timely manner. In meetings during 2022 and 2023, we raised our key interest rates by a cumulative four and a half percentage points. In effect, we moved the monetary policy stance into substantially restrictive territory; our goal was to make it sufficiently restrictive to combat the price pressures we faced.

Inflation

Over the course of 2023 and 2024, we have seen substantial progress in disinflation, the process of getting the inflation rate back to our 2 per cent target. In September, I noted that the ECB staff projections expected inflation to hit the target by the end of 2025. The incoming data since then have been broadly consistent with that view, as were the December staff projections.

Euro area inflation ticked up in the final quarter of 2024, from 1.7 per cent annually in September to 2.4 per cent in December. This increase was anticipated in recent projection exercises, largely due to energy base effects, with inflation expected to reduce once more in coming months. Nonetheless, this highlights the need to continuously evaluate the incoming data carefully ahead of each policy meeting.

The monetary policy path

With continued progress in disinflation, and with our increasing confidence that inflation will sustainably return to target well within our projection horizon (which, at the moment, is to the end of 2027), we have made a series of decisions to reduce the restrictiveness of our policy stance. Our decision yesterday reduced the Deposit Facility Rate to 2.75 per cent.

As I have said before, the direction of travel on interest rates has been clear, but without a commitment to any particular rate path. Why is this distinction important? In my view, we need to retain the flexibility to learn from the signals we observe in the incoming data between meetings and to adjust our thinking on the appropriate decisions, if necessary. This is the essence of taking a “meeting-by-meeting” approach to decision-making. 

Risks

Over the course of last year, I highlighted some important risks to the disinflation process, including that services inflation and wage growth could be more persistent than anticipated. We continue to be vigilant about any derailment of the disinflation process from stubbornly high services inflation. On that front, recent months have seen some reassuring signals including from wage trackers. Recent movements in energy prices, especially for gas, will warrant vigilance.

On the growth front, risks appear to be firmly to the downside in the euro area, not least as a result of geoeconomic fragmentation affecting patterns of international trade and investment. 

Conclusion

In my view, the high levels of uncertainty in the global environment underlines the need for prudence in our decision-making.  But underpinning yesterday’s decision was the progress in disinflation and our growing confidence that inflation would converge to target.  Some of the key data I will be looking at during this year will include trends in credit demand, firms’ investment decisions and household spending.  The Governing Council’s next monetary policy meeting is in March.

Gabriel Makhlouf