Eurozone's inflation in May fell below the 2% policy target, strengthening expectations of an interest rate cut this week

Data released by Eurostat on Tuesday showed that the eurozone's inflation rate fell more than expected to 1.9% in May, below the European Central Bank's (ECB) policy target of 2%. Economists surveyed beforehand had expected a rate of 2%, following April's rate of 2.2%.

(Source: Eurostat)

The statistics also revealed that core inflation, excluding energy, food, tobacco, and alcohol, dropped to 2.3% in May from 2.7% in April. The closely watched services inflation also cooled significantly, falling to 3.2% from 4% the previous month.

Unlike the brief dip below 2% in the eurozone's inflation rate in September last year, economists generally expect Europe's inflation rate to stabilize near the target level. In the face of tariff conflicts, the bigger question is even whether inflation will fall significantly below 2% in the future.

(Eurozone inflation rate, Source: tradingeconomics)

The ECB is set to release its latest interest rate decision in two days, with market expectations pointing to the eighth interest rate cut since June last year. Simultaneously updated economic forecasts are also likely to revise down inflation expectations and economic growth outlook. In March this year, the ECB had expected inflation to hover above the 2% target this year, only falling to 1.9% next year.

Currently, the eurozone's deposit facility rate, main refinancing rate, and marginal lending rate stand at 2.25%, 2.40%, and 2.65%, respectively. All three rates may be further cut by 25 basis points on Thursday. The market is also referring to this week's meeting as the "last easy rate cut," implying that future decision-making will become increasingly challenging.

Currently, most EU goods face a 10% US tariff, which could surge to 50% by July.

Contrary to the concerns of US Fed officials about "Trump tariffs" driving up prices, ECB officials are focused on the impact of trade wars in suppressing inflation. Potential reasons for the continued decline in European inflation include tariff-induced suppression of European goods exports, along with the appreciation of the euro (against the US dollar) and weakening oil prices due to a slowdown in global economic growth.

Given the uncertainties surrounding trade developments, the ECB will also provide scenario analysis when releasing its quarterly forecasts on Thursday. Meanwhile, European policymakers are also monitoring the inflationary effects of Germany's large-scale stimulus policy.

Katharine Neiss, Europe's chief economist at PGIM Fixed Income, pointed out that the ECB is transitioning from addressing high inflation to a new phase filled with uncertainties comparable to those during the COVID-19 pandemic and the Russia-Ukraine war. This means that central banks must be vigilant about the dual risks of inflation fluctuating around the 2% target.

Philip Lane, the chief economist of the European Central Bank, recently stated that if the institution is within its "normal central bank policy range," it is unlikely that the key policy interest rate will fall below 1.5%, as there would be no need to prevent inflation from staying persistently below the 2% target by stimulating economic growth.

He also said, "Further interest rate cuts would only be appropriate if there were more severe downside risks to inflation or a more significant slowdown in the economy."