At 1.7% year-on-year in January, inflation in the euro area now stands below the European Central Bank's 2.0% target. Compared with the previous month, it has also fallen sharply (-0.6%).
Does this open the door to cheaper credit for European households and businesses? It would certainly be welcome.
An expanding room for manoeuvre
The decline in inflation is clearly positive news for the euro area economy and for consumers. It does not, however, erase the fact that prices have risen by nearly 25% over the past five years. Initially, this increase was not matched by wage growth, leading to a significant erosion of purchasing power.
Supported by a tight labour market, wages eventually accelerated and continued to grow at a solid pace, partially offsetting the cumulative gap. This gradual catch-up helped keep the euro area economy afloat. But as wage growth loses momentum, additional support will be needed to sustain activity.
In this context, cheaper credit would likely be beneficial.
But rate changes are unexpected
At this stage, however, such a shift remains unlikely. Still concerned about a potential rebound in inflation - a scenario we view as improbable in the absence of an external shock, given subdued demand - the European Central Bank is maintaining its current stance. It signals that rates may remain unchanged for the rest of 2026. Markets continue to favour this scenario.
Nonetheless, the decline in inflation gradually expands the ECB's room for manoeuvre, reduces any prospect of further rate hikes, and may increase pressure for additional monetary easing.
Bonds and exports could benefit from lower rates
A more accommodative ECB stance would offer several advantages. First, it could provide renewed support to European bond markets. Recent declines in European yields (implying higher bond prices) have largely reflected falling US rates and safe-haven demand amid uncertainty generated by policy shifts in Washington. A more flexible ECB would offer a "Made in Europe" rationale for further bond support.
Another potential effect would be a weaker euro, which would not disadvantage exporters. The single currency remains close to equilibrium against the US dollar largely because investors expect further policy easing in the United States while euro area rates remain stable. The US policy rate currently stands between 3.5% and 3.75%, compared with a 2.15% refinancing rate in the euro area - a differential of roughly 1.5%.
This gap could narrow rapidly if the ECB keeps its policy unchanged while US rates decline. That prospect supports the euro and pushes it towards levels seen as uncomfortable by exporters. A shift in monetary policy could help address this dynamic.
Reforms are unavoidable for continuous growth
It is important not to overstate the impact: one or even several rate cuts would not resolve the structural challenges facing European industry, nor would they address the fragmentation of European services markets.
As the ECB itself has noted, a durable recovery driven by improved competitiveness and meaningful productivity gains will require progress on reforms, including those outlined in the Draghi report, intended as a roadmap for policymakers. Europe is not yet advancing at that pace, particularly in innovation.
That said, nearly three-quarters of euro area economic activity stems from services, while consumer credit has risen by 31% since early 2016. Cheaper credit would provide tangible support to households, consumption and investment.
For most households, housing-related borrowing remains the primary form of credit. Since early 2024, construction output has frequently declined, reflecting deeper tensions in a sector that is both employment-intensive and central to European real estate markets. Lower borrowing costs would not solve all issues, but a stabilised construction sector and revitalised property market would likely strengthen household confidence.
Lower inflation and cheaper credit are opportunities
The decline in euro area inflation opens a window of opportunity for the European Central Bank. While monetary policy cannot resolve the deeper structural challenges confronting Europe, it could provide palliative support in an environment of lower inflation, notably through cheaper credit conditions.
Such a scenario would be positive for households, businesses and the broader economy. It could revive domestic demand and support external trade if the euro were to move away from recent highs against the US dollar.
It would also provide additional support to European equity markets, whose recent performance has largely reflected reduced confidence in the United States, and reinforce European sovereign bond allocations.
Whether the ECB is prepared to take that step remains to be seen.
In the meantime, we continue to invest in the euro area through selected individual equities. European sovereign bonds remain part of our defensive portfolios, representing 25% of allocations. See our complete asset allocation strategy below:
