ECB on hold as Fed and Bank of England to cut rates in 2026

The incoming Fed Chair Kevin Warsh would like rates lower. 

With the first set of central bank meetings this year now in the rearview mirror, it's worth taking stock of where each of the Fed, Bank of England and ECB stands in relation to one another. 

The Fed and Bank of England can be grouped together in ‘active’ mode, with further rate cuts expected in 2026, despite both holding at their recent meetings. This makes some sense given both retain relatively (in a recent sense) tight monetary policy, with base rates in the 3.50-3.75% range. 

In contrast, the ECB cut faster, from a lower peak, to the current 2% deposit rate, and appears content at this level for the foreseeable future.

Some analysts have suggested the ECB may be forced to cut rates further this year, particularly as a stronger euro dampens import prices, energy and other commodities, but these forces are likely to be modest, so I expect the ECB will sit on its hands in 2026. With the US economy continuing to outperform, despite some softening in the labour market, relatively higher rates appear merited, albeit the incoming Fed Chair Kevin Warsh would like them lower. 

His ‘all in’ bet on AI-related productivity dampening inflation could prove prescient, but it is not a consensus view currently held by US economists, or more importantly, on the Fed’s rate-setting committee.

However, the UK economy is nowhere near the performance of the US, with growth more in league with the Eurozone, so a Bank of England rate of 3.75% on the face of it looks stifling to an economy which has averaged less than 1% GDP growth over the past three years. This was a question put to the Bank of England’s Monetary Policy Committee (MPC) at its quarterly press conference last week in relation to much lower rates in the Eurozone. The somewhat muddled answer was that the structure of each economy was different, and both were at “different points in the cycle”. One other point raised was that “supply capacity” in the UK diverges from the Eurozone. This ‘central bank speak’ alludes to the lack of public and private investment in the UK economy in recent years, which has likely fed into structurally weaker productivity growth. The successive shocks of Brexit and Covid have played a significant part in this productivity puzzle.

Indeed, over a longer time frame, UK investment trends have even lagged the less-than-stellar Eurozone, averaging around 17% of GDP between 2009-2024, compared to 20% in the Eurozone. With the UK economy underinvesting in its ‘supply side’, inflation has taken root to a greater extent as demand recovered after the pandemic, with services inflation still currently averaging 4.5% compared to a near 3% rate in the Eurozone.

While the UK labour market is now weakening, dragging wages down with it, the Bank of England’s sole mandate of low and stable inflation means a cautious approach is likely from here on rate cuts, and explains the reticence of the MPC to cut rates at its February meeting.

David McNamara is Chief Economist with AIB