ECB's 2026 Standoff: Why the Euro's Destiny Hinges on Policy Divergence

The stage is set for a fascinating divergence in 2026. The Federal Reserve has already begun its rate-cutting campaign—three cuts landed in 2025, bringing the federal funds target range down to 3.5%–3.75%. Meanwhile, the European Central Bank remains in neutral territory, holding its benchmark rate at 2.15% since July. The critical question: what happens when one central bank keeps easing meaning a shift toward looser monetary conditions while the other stays pat?

The Eurozone Economy: Sluggish, But Standing Its Ground

Don’t mistake slow for broken. The Eurozone expanded 0.2% in Q3 2025, which sounds modest until you look under the hood. Spain and France both posted 0.6% and 0.5% growth respectively, while Germany and Italy flat-lined. The European Commission’s revised forecasts tell the real story: 1.3% growth expected for 2025, 1.2% in 2026, and 1.4% in 2027. Yes, 2026 got nudged lower—a quiet warning that momentum may stall.

The structural headwinds are real. Germany’s automotive sector took a 5% hit courtesy of the EV transition and supply chain friction. Innovation spending has lagged relative to the US and China, leaving European tech segments vulnerable. Then there’s the trade wild card: the Trump administration’s reciprocal tariff approach threatens 10%–20% tariffs on EU goods. If executed, EU exports to the US could fall 3%, with autos and chemicals in the crosshairs.

The baseline is resilience without exuberance—exactly the kind of middling backdrop where central banks can afford to sit tight.

Inflation Creeping Back: The ECB’s Reason to Pause

Inflation stopped cooperating with the disinflationary script. November saw Eurozone inflation climb to 2.2% year-on-year, up from 2.1% in October, overshooting the ECB’s 2.0% target. The composition is the kicker: while energy fell 0.5%, services inflation accelerated to 3.5% from 3.4%. That’s the sticky, hard-to-kill inflation that central banks fear.

On December 18, the ECB kept all three key rates unchanged—deposit facility at 2.00%, main refinancing rate at 2.15%, marginal lending facility at 2.40%. ECB President Christine Lagarde signaled the policy stance is in a “good place,” which translates to: don’t expect action anytime soon. Market consensus aligns: a Reuters poll shows most economists penciling in unchanged ECB rates through 2026 and into 2027, though confidence drops sharply the further out forecasts extend.

Christian Kopf from Union Investment doesn’t see a near-term move; if anything shifts in 2026, he pegs it as more likely late 2026 or early 2027, and potentially in the direction of a hike. BNP Paribas chief economist Isabelle Mateos y Lago reinforces that the bar for any policy action remains high across the next several meetings.

The Fed’s Easing Trajectory: More Cuts Likely in 2026

The Fed surprised markets by delivering three cuts in 2025, exceeding its December 2024 projection of two. After pausing in March due to tariff inflation concerns, the central bank pivoted in the second half. Disinflation progress and a softening labor market opened the door. Cuts of 25 basis points came in September, October, and December, landing the funds rate at 3.5%–3.75%.

Politics adds another variable. Jerome Powell’s term ends May 2026, and reappointment looks unlikely. Trump has criticized Powell for moving slowly on cuts and suggested his successor would push easing faster. The signal: expect more dovish leadership.

Major forecasters broadly expect multiple cuts in 2026. Moody’s chief economist Mark Zandi anticipates cuts ahead, though not because the US economy is booming—rather because it’s walking a tightrope. Goldman Sachs, Morgan Stanley, Bank of America, Wells Fargo, Nomura, and Barclays are all penciling in two cuts for 2026, which would take the federal funds target to 3.00%–3.25%. Goldman targets March and June; Nomura suggests June and September.

EUR/USD in 2026: Two Paths Forward

The euro’s direction in 2026 boils down to whether European growth holds its ground while the Fed eases meaning continues cutting rates. The interest rate differential matters, but markets trade the story as much as the spread.

Scenario One: Europe Muddles Through, Fed Keeps Cutting

If Eurozone growth stays above 1.3% and inflation edges up only slowly, the ECB stays on hold. With the Fed cutting twice and the ECB paused, the yield gap narrows. Historically, that supports the euro. UBS Global Wealth Management (EMEA CIO Themis Themistocleous) backs this view: EUR/USD could climb toward 1.20 by mid-2026.

Scenario Two: European Slowdown Meets Trade Shock

If growth drops below 1.3% and trade headwinds bite, the ECB may lean toward cuts to cushion activity. That flips the narrative. EUR/USD would likely retreat from its 2025 highs back toward 1.13 support, or potentially as far as 1.10.

Where the Banks Stand

Forecasts diverge because assumptions diverge:

• Citi expects the dollar to strengthen, projecting EUR/USD at 1.10 by 2026. Their thesis: US growth re-accelerates and the Fed cuts less than markets price in. They see a potential bottom around 1.10 in Q3 2026—roughly a 6% decline from current 1.1650 levels.

• UBS takes the bullish euro stance: if the ECB holds and the Fed cuts, that yield compression supports the currency. Their target: 1.20 by mid-2026.

The Bottom Line

EUR/USD in 2026 is essentially a referendum on whether Europe’s growth proves durable enough to keep the ECB anchored while the Fed eases meaning shifts toward a series of rate reductions. If 2026 unfolds as a “Fed cuts, Europe holds” story, EUR/USD leans higher. If it becomes “Europe falters, trade shocks accelerate, ECB follows,” then 1.13 and 1.10 are no longer academic—they’re live targets. The next 12 months will hinge on data flow, Fed messaging, and whether the trade wars stay theoretical or become reality.