European Central Bank holds rates as tariffs keep policymakers on edge

The European Central Bank on Thursday kept interest rates steady amid major economic uncertainty, as the European Union scrambles to negotiate a trade agreement with the U.S. before the end of the month.

The ECB has cut interest rates at each of its four meetings so far this year, taking its key deposit facility from 3% in January to 2% in June. Last year it reduced rates from a record high of 4%.

“The environment remains exceptionally uncertain, especially because of trade disputes,” the ECB said in a statement, adding that its inflation and growth outlook from June remained supported by recent data.

While annual inflation in the euro area hit the central bank’s 2% target last month, traders widely expected a hold in July — in large part due to geopolitical volatility. The U.S. is the EU’s biggest bilateral trade and investment partner and the 27-member bloc exported 503 billion euros ($590 billion) in goods to the States last year.

As of Thursday, the future of that trade relationship remained up in the air, with one possibility being a 15% baseline tariff rate on all EU imports to the U.S., along with retaliatory measures on the EU’s part.

ECB officials have been suggesting for some time that their work in bringing down inflation is nearly done, as it hunts for the so-called neutral level at which rates are neither stimulating, nor restricting growth. ECB Chief Economist Philip Lane told CNBC earlier this month that “the last cycle is done, bringing inflation down,” but that policymakers would remain alert to any changes in the medium-term outlook.

In a news conference following the decision, ECB President Christine Lagarde said that the euro zone economy had performed better than expected in the first quarter. That was partly because of front-loading of exports ahead of expected tariff hikes, but also due to stronger private consumption and investment, rising real incomes and easier financing conditions, she said.

Stressing current levels of uncertainty in forecasting, Lagarde went on to say that risks to growth were “tilted to the downside,” with an escalation in trade tensions potentially dragging down exports, investment and consumption, as well as weighing on business and household sentiment.

Conversely, a quick resolution in trade tensions along with higher European defense and infrastructure spending could boost growth more than previously forecast in the coming months, she said.

Investors have been keen to assess whether the central bank is concerned about the recent appreciation in the euro, which can have a deflationary effect as imports get cheaper.

Lagarde noted Thursday that a stronger euro could “bring inflation down further than expected” and that higher global tariffs could concurrently dampen price rises, if countries with overcapacity reroute their exports to the euro area. The euro was choppy following the ECB decision, trading around 0.08% lower against the U.S. dollar at 5:32 p.m. in London at $1.176. That is still up from a rate of around $1.026 at the start of the year, as investors have broadly shifted away from the greenback due to political and fiscal uncertainty.

However, Lagarde again stressed that the ECB is monitoring a flip-side scenario in which fragmented supply chains constrain the domestic economy and push up prices worldwide. Higher fiscal spending and extreme weather events also risk an uptick in inflation, she said, describing the current situation as “wait and watch” but policy overall as in a “good place.”

Economists at RBC Capital Markets said in a note that Lagarde’s press conference appeared to emphasise positive signals coming from the euro area economy and downplay concerns about inflation weakness, leading them to change their call to a hold on rates at 2% for the remainder of the year.

Joe Nellis, economic advisor at accountancy MHA, said one more rate cut may still come in 2025, but that the ECB would wait to confirm that 30% U.S. tariffs on EU goods from Aug. 1 can be avoided.

“If a U.S.-EU trade deal isn’t reached beforehand, the ECB may look at cutting rates again in September to counter-act the barriers to economic growth that tariffs will impose,” Nellis said.

Mark Wall, chief European economist at Deutsche Bank, said that the ECB would be keeping all options on the table — which could even mean a return to rate hikes on the horizon.

“If trade uncertainty fades, the combination of a resilient economy and significant fiscal easing will eventually translate into upside risks to inflation. Markets are not far away from switching focus from the last cut to the first hike,” Wall said.