The European Central Bank (ECB) is expected to deliver another 25-basis point cut to its key interest rates at the March monetary policy meeting. But the outlook thereafter has been clouded by hawkish comments from influential Governing Council members, particularly Isabel Schnabel, as well as an improving near-term growth outlook.

The recent spot activity data has remained weak. Q4 real GDP growth printed below the ECB staff’s December projections, the forward-looking components of the PMI indices remain in contractionary territory and employment growth continues to slow. However, green shoots to the outlook are emerging. Momentum in the PMIs appear to have bottomed; growth data has surprised to the upside since the start of the year (relative to admittedly quite depressed expectations), and a positive demand impulse is expected from greater defence spending and the prospect of a ceasefire in Ukraine. We expect growth would be boosted by 0.2-0.3 percentage points (ppts) should European defence spending rise to 2.5% of GDP by the end of 2026 and expect an additional 0.2-0.3 ppts impulse should a “fragile” ceasefire be agreed.

However, the prospect of additional tariffs continues to weigh on the outlook. We don’t believe a reciprocal tariff strategy, nor a 25% tariff on autos, will have a material impact on fundamentals. But implementing tariffs to match EU VAT rates, or a blanket 25% tariff on all EU goods, would be significant and likely wipe out any gains from defence spending and a ceasefire.

Meanwhile, the inflation outlook continues to look benign. We are encouraged by the drop in services inflation in the flash February report and have strong conviction there is more room to go. A large chunk of the recent stickiness is down to three components – insurance, tourism, and transport – all of which show signs of normalising in the coming months. The labour market also continues to loosen, whilst real-time wage trackers point to a sharp drop in annual wage growth by year-end.

Much of the recent policy debate has centred around whether interest rates are still restrictive. This was brought to the fore by Executive Board member Isabel Schnabel’s view that policy should no longer be described as “clearly restrictive”. We agree with this, given policy is likely be at the top end of our 2-2.5% neutral range later this week.

With growth set to remain below-trend this year and a material chance inflation will undershoot the 2% target in the medium term, we stick to our call of sequential rate cuts until July, which would leave the policy rate at 1.75%, a touch below neutral. But the news in the last six weeks of greater defence spending and a potential ceasefire in Ukraine skews to the risks to our outlook to stronger growth and therefore a slower pace of rate cuts.