The European Central Bank cut interest rates by 100bps in 2024 and UBS thinks it is on course to do the same this year, taking the deposit rate to 2%.

Given how quickly inflation pressures in the eurozone have eased, the bank expects the ECB will have the confidence to continue with its meeting-by-meeting pace of quarter-point rate cuts, implying that it should reach its destination by June.

Whether this will mark the end of the cutting cycle is as yet
unclear, stated UBS. The widely held perception is that with
economic growth seemingly faltering, the ECB will be forced
to do more to support the economy in the coming quarters,
taking monetary policy below neutral -- which UBS assumes to be around the 2% level -- and into easing territory.

In the bank's view, the risks to this outlook are a little more balanced.

While UBS doesn't expect to see a strong performance for the eurozone this year, with growth likely coming in around the 1% mark, this would represent an economy that is growing at its long-term potential.

In addition, while inflation pressures have eased, they haven't disappeared entirely, especially when looking at the medium term, wrote the bank in a note to clients. With labor markets showing a degree of resilience, wages are still likely to rise in real terms.

Additionally, the negative drag from fiscal consolidation is unlikely to last as governments need to spend more on defense and infrastructure, including for the green-energy transition, as well as catering to the needs of an aging population.

For the ECB to go further this year, the bank's sense is that one or many of the current threats to the global economy
would need to materialize. The threat of trade tariffs is
probably the most impactful.

Tariffs on European exports could dampen demand, leading to weaker pricing power for firms at home, but perhaps a bigger threat to the eurozone and global inflation pressure comes from a trade dispute between the United States and China, pointed out UBS.

With excess capacity already evident in Chinese production, fewer exports to the U.S. could mean that goods are directed elsewhere, placing further downward pressure on prices. Without some action to offset this, Europe could be particularly vulnerable to such a disinflationary wave, which may force the ECB's hand.

UBS cannot rule out that the ECB will take interest rates
below 2% in the next year, but for now, this remains a
risk case. Weaker-than-expected growth or inflation could
prompt such a move, but with the euro already flirting with
parity against the US dollar, policymakers will need to be
mindful of the inflationary pressures that could result if it
fell further.

To be sure, exchange rate pass-through into inflation is never as high as commonly assumed. Equally, with a lot of international goods priced in USD, they aren't negligible and likely enough to keep any interest rate divergence between the U.S. and the eurozone from going too far.