In September 2025, the European Central Bank (ECB) made the most significant decision in the post-pandemic period, lowering the key deposit rate by 25 basis points to 3.5%. As the European Union struggled with a persistent inflationary shock for nearly two years, the central bank officials were preparing to embark on a path of gradual tightening.
However, they remained acutely aware of the risks of premature tightening and the dangers of "renationalization" of monetary policy. Thus, while President Christine Lagarde noted that "falling inflation is good news," she hastened to add that "inflation is far from over" in the euro area.
Inflation Down, But Not Out
After spiking to 10.6% in 2022, inflation in the Eurozone dropped to 2.3% in August 2025. With energy prices stabilized, food inflation disappeared, and supply chains restored, overall inflation is well on its way to returning to the ECB's 2% target. Meanwhile, "core" inflation, which excludes food and energy, remained sticky around 2.8%, reflecting persistent price pressures in services, housing, and wages.
ECB policymakers acknowledged that the situation was conducive to reconsidering the tightening cycle as the "last mile" of disinflation is the most difficult one to cover. Indeed, already in 2011, the ECB had erroneously accelerated the tapering, causing prolonged stagnation. Therefore, the Frankfurt-based policymakers remained cautious about additional rate hikes in 2025.
Divergent Europe
The heterogeneous nature of the Eurozone's economies also complicated the ECB's efforts to normalize monetary policy. While Southern Europe continued to grow at a healthy pace, fueled by tourism, Germany, the economic powerhouse of the EU, approached recession. At the same time, the fiscal policy of France and the current account of the Netherlands were also cause for concern for the ECB. In other words, the situation in the EU was complicated by the differing economic realities of individual countries.
From a monetary policy perspective, this creates significant challenges for the ECB, as easing is necessary to prevent a recession in Germany, while tighter policy is required to prevent excessive wage inflation in the south. "Monetary policy is a blunt instrument in a mosaic economy," one of the central bank officials remarked, noting the difficulty of the ECB's task of balancing the needs of individual countries.
The Fiscal Constraint
While the ECB continued its accommodative cycle, fiscal consolidation throughout the EU continued at a steady pace. With pandemic-related fiscal stimuli unwound, government debts and deficits returned to the limits of the Stability and Growth Pact. Nevertheless, governments continued to pursue contradictory fiscal policies, balancing the need for austerity with the need for public investment in modern economies.
In general, however, Germany, the largest EU economy, took a more prudent direction, promising to introduce a fiscal stimulus to rescue the faltering industrial sector. Elsewhere, fiscal policy was more expansionary, with France, for example, introducing generous tax breaks for green business investments. At the same time, the economies of Southern Europe relied on the EU's recovery fund, so their fiscal policies remained relatively prudent. Overall, while individual governments continued to pursue expansionary fiscal policies, they were all committed to avoiding a damaging policy mix with monetary policy.
Labor Markets
The labor market in the Eurozone continued to perform strongly, with only a few countries registering significant job shortages. These were primarily in healthcare, logistics, and information technology. Meanwhile, wage growth, on average, across the EU, exceeded inflation by about 4%, which allowed most workers to keep up with the price level.
Nevertheless, from the perspective of the central bank, this development could quickly turn negative. A surge in wages, especially if it occurs throughout the economy, increases the risk of inflation overshooting the ECB's target. However, wage moderation, when skillfully negotiated between workers and employers, can be an effective way to fight inflation. Thus, for example, in Germany, large trade unions and company management had reached an agreement on multi-year wage growth linked to productivity. Some experts even consider this to be a best practice in modern macroeconomic policy, as it ensures social partnership between different factions of the economy.
Summary and Outlook
The ECB's monetary policy in 2025 reflects a textbook balancing act between cautious optimism and recession fears. While the central bank officials recognized that inflation was on a downward path and it was safe to ease policy, they remained pessimistic about the medium-term prospects. Thus, the ECB found itself caught between the need to stimulate the faltering economy and the fear of "renationalization" of monetary policy.
Indeed, the ECB's actions in 2025 will be a crucial test of its credibility, as the soft landing of the inflation shock will greatly enhance the ECB's reputation. Conversely, even small miscalculations on the part of the ECB can lead Europe into another political and economic crisis.