European Central Bank cuts rates as possible trade war looms

The European Central Bank (ECB) 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 European defence spending, two factors that could upend expectations for growth and inflation.

US President Donald Trump has imposed 25% tariffs on Canada and Mexico that affect Europe indirectly through companies that have plants in those countries, and has threatened the EU with similar measures against its car imports and other goods.

That is already having an impact, said ECB head Christine Lagarde, who said that tariffs “are not good at all and are net negative on pretty much all accounts”.

“It’s even negative before it happens because the uncertainty that is generated and the undermined confidence that results from just the threat of those tariff increases and potential retaliations are putting a brake on investment, on consumption decisions, on employment, hiring and all the rest of it,” she said at her post-decision news conference.

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 trade policy.

Ms Lagarde said at her post-meeting news conference that with the cut, rates were “meaningfully less restrictive” on economic activity. While she added that the bank was “not pre-committing to a particular rate path”, she opened the door to interrupting the current series of rate cuts in April.

“We will have to be agile to respond to the data. But as I said, if the data indicates that the most appropriate monetary policy stance is a cut, it will be a cut,” she said. “If, on the other hand, the data indicates that the most appropriate decision is not to cut, then it will be a pause.”

She acknowledged conflicting pressures ahead from a trade conflict that could depress growth and the prospect of more government spending on defence, which could boost growth but also 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.

European Union leaders are holding emergency talks to agree on ways to quickly increase their military budgets after the Trump administration signalled that Europe must take care of its own security and also suspended assistance to Ukraine.

Meanwhile, 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.

“A pause at the next meeting to come to terms with the new macro reality now looks like a possibility,” said Carsten Brzeski, chief of global macro at ING bank.