A Steady Hand: why the Governing Council held rates at 2 per cent this week

At our meeting this week in Frankfurt, and for the fifth consecutive time since June 2025, the Governing Council kept its main policy interest rate (the deposit facility rate) unchanged at 2 per cent.

Despite a small undershoot in the latest data – headline inflation in the euro area was 1.7 per cent in January – inflation remains in-line with our projections. Excluding the more volatile energy and food components, core inflation was 2.2 per cent. 

If the macro environment continues to evolve in-line with our projections, I see this as being consistent with achieving our price stability goal, namely: 2 per cent inflation over the medium term. However, given the uncertain geopolitical environment, this is a big ‘if’. As we saw in recent weeks, intertwined geopolitical and economic risks to the outlook are both two-sided and wide-ranging. It is therefore important not to pre-commit to an interest rate path. This allows us to be flexible, to respond events that could cause inflation to deviate persistently from our target in either direction.

The forces driving euro area inflation

The inflation picture, while improved, remains a patchwork of competing forces.

Services inflation was 3.2 per cent in January, down from 3.4 per cent in December. This is edging closer to the 3 per cent level I have highlighted in the past as one that I see as being more consistent with the target. Labour costs are a potential cost-push driver of price-setting for services firms, and we have seen significant wage growth moderation after the staggered adjustment of wages to the inflation surge. Soft data on firms expectations also point to an easing of labour cost pressures in the year ahead. But, after the wage drift we observed towards the end of last year – when outturn wage growth turned out to be above what we expected based on the ECB negotiated wage tracker – we await hard data on wage growth for the first half of this year.

Outside of services, energy prices fell 4.1 per cent year-on-year. Accounting for just under 10 per cent of spending in the average household’s basket, this is contributing to lower than 2 per cent headline inflation. Food inflation of 2.7 per cent in January remains above its pre-pandemic average of around 2 per cent while goods inflation continues on the weak path it has been on since mid-2024, at 0.4 per cent in January. For food, recent trends point to an easing of price momentum in meat and commodities, the two main contributors to strong food inflation in 2025.

One question I have been asked is whether the headline figure suggests monetary policy might even be too tight? On the basis of the current data, combined with the ECB/Eurosystem projections, my answer is no. We see from the core inflation figure of 2.2 per cent in January that underlying price pressures are moving in a direction consistent with our target.  Furthermore, notwithstanding comforting signals from negotiated wages and soft data, until we start seeing data for 2026 there is lingering uncertainty about the path for wages. For me, our data-dependent approach calls for patience rather than action at this stage.

Resilient growth in a challenging environment

The euro area economy expanded by 0.3 per cent in the fourth quarter of 2025, matching the previous quarter and slightly exceeding expectations. For the full year, euro area GDP grew 1.5 per cent, a meaningful improvement from the 0.9 per cent recorded in 2024.  

Amongst the larger countries, Spain continues to be a standout performer, expanding by 0.8 per cent in Q4, or an annualised growth rate of 3.2 per cent. The uplift to domestic demand in Germany, in part attributable to increased spending on infrastructure and defence, also saw growth surprise to the upside in the fourth quarter (0.3 per cent quarter-on-quarter growth, or 1.2 per cent annualised).

For the euro area as whole, the Q4 data suggest some small upside risk to the December projections of 1.2 per cent growth in 2026. Overall, it remains a picture of moderate but steady expansion – not exactly spectacular, but enough to suggest the economy has found its feet after years of successive crises.

That said, growth remains anaemic by historical standards. And while a euro area growth rate of 1.2 – 1.5 per cent is close to, or even at, potential, it masks the fact that some countries — particularly manufacturing-heavy economies – are struggling to gain traction. 

Such a low level of potential growth is a concern. With demographic headwinds (peaking or declining working age populations, even with migration) and weak productivity dragging on growth, I have been vocal in my support for the Draghi and Letta reports. I will return to this theme later in the year, focusing on those reforms that matter most for the central banks, but as I said recently, “[i]f we want to have a modern, innovative, integrated and productive European economy that realises its potential, that is prepared for tomorrow’s challenges, and that is delivering for its citizens, then we need to choose a different path than the one we appear to be on.” This means implementing the reports’ proposals – around the single market, the savings and investment union, regulatory simplification, an integrated approach to innovation, strategic sector integration and resilience in key infrastructure – as a matter of urgency.

Risks to the outlook

The current 2 per cent deposit rate balances keeping inflation expectations anchored, while also supporting the recovery. Two risks to the outlook are that the current inflation undershoot becomes more entrenched or that growth loses momentum. 

On the undershoot, long-run inflation expectations remain anchored at our 2 per cent target. This does not currently suggest a persistent undershoot dynamic, but we continue to closely monitor developments here. Given the importance of wage setting for firms’ overall costs, especially those with a large labour share, this is another area that warrants close attention. Forward-looking information from firm surveys and forecasters shows wage growth settling around 3 per cent in 2026-28, despite a cooling of labour demand in recent months. Wage growth around this level would mitigate the risk of a persistent inflation undershoot.

On growth, ongoing trade policy uncertainty and geopolitical tensions could be negative for investment and employment decisions. We will continue to monitor developments as we prepare for our next meeting, which will include updated projections, in March.

Gabriel Makhlouf