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The ECB is widely expected to keep rates unchanged after its monetary policy meeting on Thursday, the first decision of the new year. Despite the strong consensus and market pricing, there is a chance that it could rile up markets a bit. Some analysts warn that the ECB won’t be able to stay on the sidelines much longer and might soon signal a dovish shift again.

It’s been a year since the ECB brought inflation back to target after the pandemic and the Russian invasion of Ukraine drove up consumer prices. For months, President Christine Lagarde has repeatedly said that monetary policy and inflation are in a good place. Europe’s largest central bank was among the first to normalize monetary policy this cycle. But that also means it could be among the first to respond to the changing economic and geopolitical situation.
 

Inflation Dipping Below Target

After a few years of dealing with high inflation, the ECB could return to face its previous, decades-long headache: low inflation. Central banks aim to maintain stable, modest inflation to encourage spending and boost economic activity. If inflation is persistently below target, the central bank can be blamed for the lack of economic growth.

Of course, there are natural ups and downs in the inflation rate, but as long as it stays within a couple of decimals of the target on both sides, the central bank can keep policy unchanged. The ECB’s problem now is that it expects inflation to continue to cool and fall below its target in the coming months. This drop could be exacerbated if the dollar weakens and the Euro gets relatively stronger. Imports would cost less, lowering consumer prices. Slower economic activity can also reduce inflationary pressures.
 

The Timing is the Key

Most economists agree that sluggish growth in the Eurozone, coupled with a relatively strong Euro, will translate into lower inflation this year. The question for forex traders is when the downward pressure will be enough to move the ECB to cut. Long before the actual cut, the ECB will likely start signalling a dovish bias, hoping to push prices back to target.

A dovish ECB would weigh on the Euro and keep inflation from falling too far. When the dollar tanked last week in response to Trump’s comments favoring a weaker greenback, the ECB was quick to issue a warning. This suggests that ECB officials are wary of the euro becoming too strong and could use a rate decision meeting to tweak their rhetoric to weaken the currency.
 

Inflation and Rate Decision

A day before the ECB decision, the flash January CPI figures for the Eurozone are released. The consensus is that the headline rate will dip to 1.8% from 1.9%, while the core rate remains unchanged at 2.3%. We should remember that the ECB doesn’t have a mandate to focus on the core rate, so if inflation is lower than anticipated, it could worry officials in Frankfurt. The Euro could weaken in anticipation of a dovish signal from the ECB on Thursday.

On the other hand, stronger-than-expected inflation could leave the ECB sticking to its current rhetoric. That would likely keep the Euro strong and possibly head back toward the key 1.2000 handle.

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