ECB set to stay on hold, despite inflation undershoot

The tone of the communication suggests that it would most likely remain on hold in the coming months, even though its projections show inflation undershooting its 2% goal in both 2026 and 2027. Indeed, headline inflation is seen at 1.7% (previously 1.6%) in 2026 and 1.9% (2% previously), while core inflation is seen at 1.9% (unchanged) in 2026 and 1.8% (from 1.9%) in 2027. The main reason that headline is above the core, is upward pressure on energy from the introduction of ETS-2. President Lagarde characterised the move lower in core inflation in 2027 as being driven by the stronger euro and declining labour cost pressures.

The Governing Council is not cutting interest rates in response to the inflation undershoot for a number of reasons. First, it considers the undershoot as being too small to act on. President Lagarde suggested that the 1.9% was a “fat 1.9%” suggesting it was only a few decimals away from the 2%. Its strategy update had concluded that ‘minimal deviations’ of inflation should not always prompt ECB moves. Officials judged that they acting would represent an “over-engineering” of policy. Second, the ECB had become more optimistic on the economic outlook and now saw risks as being “more balanced”, while they had previously been on the downside. This reflect that “recent trade agreements have reduced uncertainty”. Third, the ECB judged that various indicators of underlying inflation were consistent with the 2% target, even though actual core inflation was below it. Indeed, looking below the surface of the annual inflation forecasts offers an additional clue explaining the ECB’s ambivalence over the inflation undershoot: the quarterly projections point to inflation moving higher again at the very end of the horizon in late 2027 (in the case of headline inflation, it is back at 2% by Q4 2027).

Although the Council has not closed the door to rate cuts as it continues to follow “a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance” we think it is most likely that the ECB will keep interest rates on hold going forward. As long as the economy remains resilient and on track for a recovery next year, we think it will likely keep interest rates on hold. The risk to our base case over the next 3-6 months is tilted toward rate cuts because of the possibility of stronger euro (the ECB assumes EUR/USD to be 1.16 in 2026 and 2027) and lower oil prices (Brent is seen around 65 $/pb in 2026 and 2027) than the ECB has factored in.

Finally, the ECB does not seem to be concerned about sovereign bond market developments in the eurozone or France in particular. President Lagarde noted that bond markets were operating smoothly with good liquidity, while country spreads were tight. Indeed, she noted that the TPI was not even discussed. This is in line with our view that market rates are not even close to levels that would trigger any kind of response from the ECB, either in terms of outright yields generally, or for instance France’s spread over Germany.