Falling inflation and the European Central Bank’s (ECB) conviction that price increases will stabilize around two percent annually in the long run made it possible for Frankfurt to announce another rate cut earlier this month. With this move, the policy rate has now been more than halved compared to the summer of 2024. The ECB seems to be casting out the interest rate anchor and allowing itself to drift for a while.
On the one hand, inflation trends give no reason to take further action. ECB economists expect annual inflation in the eurozone to come in at two percent this year, followed by a drop to 1.6 percent next year, then a rise back toward two percent in 2027. In other words, a continued decline toward one percent is unlikely, which means additional rate cuts are not necessarily needed. However, since the bank expects prices to increase by around two percent annually in the coming years, there’s also no need for rate hikes.
On the other hand, projected developments in economic activity also seem to warrant no further action. ECB economists foresee eurozone GDP growing at just over one percent annually through 2027. This is not a scenario that calls for aggressive interest rate cuts or hikes. It’s closely tied to the potential growth rate of the eurozone economy, which is roughly estimated at about one percent per year. Potential growth refers to the rate at which the economy can expand without causing upward or downward pressure on inflation.
Output gap
Adding to this, the ECB expects the so-called output gap to close by 2027. The output gap reflects the accumulated difference between actual economic growth and potential growth over recent years. When actual growth lags behind potential growth, we speak of an output gap—essentially the amount of slack in the economy that allows for extra growth without triggering inflation. Think of it like mobile phone plans from not so long ago, which came with a set number of minutes per month—say, 500.
If you used more than 500 minutes in a month, you had to pay extra. But if, in the months before, you had used fewer minutes—say, 300 minutes per month for two months—you couldn’t carry over those unused minutes. You couldn’t suddenly use 900 minutes in one month without paying more.
What the ECB is saying is that by 2027, those extra economic “rollover minutes” will be used up. In practical terms, the bank expects that economic growth in the coming years will not bring meaningful inflationary pressure.
And so ECB President Christine Lagarde was able to state that the central bank is “almost done” with the rate-cutting cycle—a response to factors such as the war in Ukraine, the energy crisis, and lingering effects from the pandemic.
The 21st Eurozone member
There is, however, news on a different front. The ECB’s household will soon gain a new member: on January 1, 2026, Bulgaria will become the 21st country to adopt the euro. This means an extra seat must be added at the ECB Governing Council’s table for the Bulgarian central banker.
First, let’s clear up a persistent misconception about euro adoption. Joining the euro is not something EU member states can do at will. Under EU rules, every member is obligated to adopt the euro once it meets a set of specific criteria. These include requirements on inflation, public debt, budget deficits, and interest rates.
The ECB will no doubt celebrate Bulgaria’s entry. Still, I wouldn’t break out the balloons and streamers just yet. In fact, I’d be more inclined to worry. Why? Because economically strong, innovative, and wealthy EU members like Sweden and Denmark—as well as fast-growing Poland—have no intention of adopting the euro. These countries deliberately avoid meeting all the criteria, thereby keeping the eurozone’s green light from ever turning on. If those nations are doing everything they can not to join the euro, that speaks volumes.
Edin Mujagić is an economist, fund manager at Hoofbosch Investment Fund, and author of Turning Point 1971. He writes a monthly ECB Watch column on European Central Bank monetary policy for Investment Officer.