The European Central Bank has already its key interest rates by 100 basis points in 2024 from the decade-high levels set earlier in 2023, but on Monday 16 December 2024, just a week after the last monetary policy meeting of the year, ECB president Christine Lagarde indicated that more rate cuts were likely in 2025. She , “If the incoming data continue to confirm our baseline, the direction of travel is clear and we expect to lower interest rates further,” giving markets a clear signal of further easing.

Lagarde made these remarks in Vilnius, Lithuania, where she was marking the tenth anniversary of Lithuania’s adoption of the euro. While acknowledging Lithuania’s economic progress since joining the euro area, Lagarde primarily focused on the current state and future direction of ECB monetary policy. She also clarified that the ECB is shifting its policy approach, moving away from a restrictive stance towards a more flexible, data-driven framework.

Policy shift

Lagarde said that the ECB’s policy stance had recently evolved. For much of 2024, the ECB maintained a restrictive bias in its communication, focusing on curbing inflation. However, following a steady improvement in the inflation outlook, the ECB governing council, its rate-setting body, decided to remove this restrictive bias during its most recent meeting. Lagarde clarified in her comments this week that the evolving economic conditions now warranted a shift from an emphasis on “sufficiently restrictive” rates to a focus on “appropriate” policy settings.

The shift in policy approach was driven by three key developments that increased the ECB’s confidence in achieving its inflation target, Lagarde explained. These developments related to the path of inflation, the nature of the shocks affecting inflation and the evolving risks to future inflation.

Inflation path

Lagarde’s first point of focus was the improving inflation trajectory. Early in the monetary tightening cycle, inflation projections were marked by high uncertainty, with the return to the ECB's target consistently being delayed. According to machine learning models developed by the ECB, inflation uncertainty in 2022 and 2023 was four to five times higher than the long-term average. By September 2024, however, six consecutive forecast rounds showed inflation on track to reach the 2% target by 2025, with the uncertainty around these projections significantly reduced, returning to pre-pandemic levels.

This increased certainty was confirmed by the accuracy of inflation forecasts, which had improved significantly since early 2023. Projections for headline inflation had aligned more closely with actual outcomes, while errors for core inflation also began to normalise in 2024.

Inflation shocks

The second key shift identified by Lagarde related to the evolving nature of inflationary shocks. The euro area had been grappling with a series of large, persistent shocks, particularly in energy prices and wages, that had complicated the inflationary process. These shocks had transmitted unevenly across the economy, making it difficult to predict their full impact on inflation.

In response, the ECB had developed a reaction function based on three main criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission. By focusing on underlying inflation trends, the ECB was better able to assess the persistence of inflationary pressures and calibrate its policy stance accordingly.

Lagarde pointed to signs that inflationary pressures were receding, particularly in the services sector, where inflation had been slower to adjust. While domestic inflation, mainly driven by services, remained higher than desired, the ECB expected this to decrease in the coming months as wage growth slowed and previous price increases faded. The ECB’s wage tracker suggested a slowdown in wage growth from 4.8% in 2024 to about 3% in 2025, which aligns with the ECB’s 2% inflation target.

Inflation risks

Lagarde’s third point of focus was the changing risks to inflation. As past shocks gradually faded, the risks to inflation shifted towards potential future shocks, particularly related to economic growth and geopolitical events. She highlighted a significant downgrade in the euro area’s growth outlook, with projections for 2024 revised down from 1.5% to 0.7%. This slowdown was attributed to weak export performance and a subdued domestic economy, particularly in investment and consumption.

Lagarde also noted persistent caution among euro area consumers. Despite historically high employment levels and rising real incomes, households had been saving a larger share of their income and remained reluctant to increase spending. She attributed this cautious behaviour to a perception gap: many households were underestimating their real income growth, despite actual increases driven by past inflation. However, Lagarde pointed out that this pessimism could dissipate as the high-inflation episode moved into the past, though new geopolitical uncertainties, such as potential protectionist shifts in the United States, could dampen growth prospects.

Policy implications

Lagarde laid out the key implications for ECB monetary policy in light of recent developments. First, she reiterated that the ECB’s current policy stance remained restrictive, but the direction ahead is clear: if incoming data align with the baseline outlook, further rate cuts would be likely.

Second, Lagarde emphasised the ongoing importance of the ECB’s reaction function. This framework had played a crucial role in managing inflation during the high-inflation period, and the ECB would maintain close monitoring of underlying inflation, adapting its policy as necessary to address future shocks. This flexibility would be vital, particularly in the face of potential geopolitical disruptions to monetary transmission.

Finally, Lagarde noted that the ECB was approaching a point where the policy horizon could extend beyond the immediate transmission lag. This shift from a focus on achieving a “timely” return to the target to prioritising “sustainable” inflation convergence marked a transition to a more flexible policy approach, positioning the ECB to respond effectively to future shocks.

Lagarde concluded her remarks by reflecting on the cyclical nature of the ECB’s monetary policy, drawing a parallel to the changing seasons in Lithuanian poet Kristijonas Donelaitis’ “The Seasons” (Metai). While the darkest days of winter appeared to be behind the euro area economy, she cautioned that considerable uncertainty remained. The ECB, she assured, would remain prepared to navigate these uncertainties, ensuring that “our monetary policy will be prepared for all scenarios to come.”