Deflationary Temptation: Why the ECB May Cut Rates Further Amid Mixed Inflation Signals

The latest German inflation data offers a glimpse into the European Central Bank’s (ECB) delicate balancing act between easing monetary policy and guarding against persistent price pressures. With headline inflation easing to 2.1% in April 2025, down from 2.3% in March, the case for further rate cuts has strengthened. Yet core inflation—particularly in services—remains stubbornly elevated, complicating the ECB’s path. The interplay between these trends, alongside weak Eurozone growth, sets the stage for a pivotal policy decision in coming months.

The Inflation Divergence: Headline Relief vs. Services Pressure

Germany’s April inflation report highlights a stark contrast: while headline inflation dipped to its lowest level since October 2024, core inflation (excluding food and energy) rose to 2.9%, its highest since late 2023. The decline in energy prices—down -5.4% year-on-year—provided critical relief, but services inflation, driven by wage growth and tight labor markets, climbed to 3.9%, its fastest pace in over a year. This divergence mirrors Eurozone-wide trends, where core inflation is projected to hold at 2.5% despite headline rates dipping toward the ECB’s 2% target.

The ecb faces a dilemma: headline inflation is nearing its goal, but core inflation—a better gauge of underlying price dynamics—suggests lingering pressures. “The ECB will have to decide whether to prioritize the headline’s proximity to target or the risk that services inflation could rebound,” said Clara Kim, an economist at Capital Economics.

ECB’s Data-Driven Path to Rate Cuts

The ECB’s April rate cut to 2.25% marked its sixth consecutive easing move since late 2023. With inflation projections now pointing to a potential dip below 2% by late 2025, markets are pricing in further reductions. The latest Eurozone GDP flash estimate of 0.4% quarterly growth (still preliminary) underscores why: weak economic momentum, especially in Germany—the Eurozone’s largest economy—reinforces the need for accommodative policy.

The bond market has already priced in aggressive easing, with Germany’s 10-year yields falling to 1.8%, a level not seen since mid-2022.

Risks on the Horizon: Trade Wars and Wage Dynamics

Despite the inflationary easing, risks remain. Geopolitical tensions, particularly U.S. tariff threats, could disrupt supply chains and reignite inflation. Meanwhile, wage growth in Germany, though slowing to 4.1% annually, still outpaces productivity gains, keeping services inflation elevated.

“The ECB must ask: Is core inflation a temporary blip, or a sign of deeper wage-price pressures?” said Marco Polo, head of macro research at Allianz. “If services inflation stays above 3%, the ECB’s hands could be tied, even if headline rates fall.”

Conclusion: The ECB’s Calculated Gamble

The ECB is likely to cut rates further, with at least one 25-basis-point reduction expected by year-end, driven by headline inflation’s proximity to target and weak growth. However, the services sector’s resilience poses a critical risk.

• Key Data Points:
• Eurozone inflation is projected to reach 2.1% in April (vs. 2.2% in March).
• German GDP contracted -0.2% year-on-year in Q1 2025, signaling economic fragility.
• Core inflation’s 2.9% rate in Germany suggests underlying pressures remain.

Investors should prepare for a gradual easing cycle, but not without volatility. The ECB’s success hinges on whether disinflation in energy and goods outpaces services’ upward drift. For now, the deflationary winds are blowing in the ECB’s favor—but the storm clouds of trade wars and wage growth linger on the horizon.

The widening gap between core and headline inflation since late 2023 underscores the ECB’s challenge: the path to 2% is narrowing, but the destination remains uncertain.