Europe’s Policy Trap: When Fighting Inflation Risks Breaking the Economy

For traders, it’s a market defined by divergence, between a cautious Federal Reserve and a cornered European Central Bank, between resilient rhetoric and weakening fundamentals.

The core conflict facing the Euro is that the ECB remains trapped by stubborn price pressures while the region’s economic fundamentals continue to erode. The tension is amplified by policy divergence, with the Fed turning dovish amid concerns about the labor market, while the ECB remains reluctant to ease.

Internal risks with the Eurozone, from France’s fiscal challenges to Germany’s deepening slowdown, add another layer of fragility. Externally, rising geopolitical tensions, particularly the renewed US-China trade dispute, further darken the outlook.

Market sentiment, meanwhile, remains cautiously optimistic. Speculative positioning suggests a bullish stance of the Euro, indicating that much of the positive narrative, including policy divergence, may already be priced in. That makes the single currency increasingly vulnerable to negative surprises in economic data.

Snapshot of Key Macroeconomic Indicators (as of October 21, 2025)

 

The stickiness of core inflation is almost entirely driven by the services sector, where inflation edged up from 3.1% to 3.2%.

Services inflation is a closely watched indicator by the ECB. It is closely linked to domestic demand and wage growth, is less susceptible to global factors, and is harder to control through monetary policy.

In contrast, non-energy industrial goods inflation remains subdued, holding steady at 0.8% 2, indicating continued weak demand in the manufacturing sector. This internal structural divergence – hot services and cold industrial goods – makes the ECB’s policy decisions exceptionally complex.

Inflation trends in the Eurozone vary considerably across its member states.

Germany, as the largest economy in the Eurozone, saw its inflation rate unexpectedly rise to 2.4%, mainly driven by strong services CPI. Meanwhile, France’s inflation was much milder, at only 1.1%. This divergence poses a significant challenge to the ECB “one-size-fits-all” monetary policy. Tightening policies to curb inflation in Germany could cause unnecessary harm to lower-inflation economies like France.

The combination of above-target headline inflation and accelerating core inflation has effectively closed the door to another ECB rate cut in 2025. The central bank is now locked into a data-dependent decision-making mode, and current data clearly indicates that “inflation has not yet been defeated.”

This solidifies its hawkish policy stance, which alone is beneficial for the Euro. Recent remarks by ECB President Christine Lagarde have also repeatedly emphasized the determination to bring inflation back to target, further reinforcing this message.

The latest German ZEW survey shows that the economic current situation index has fallen to a deep abyss of -80.0, indicating that the economy is under immense pressure. ECB is forced to prioritize fighting stubborn service sector inflation, even if it means bringing more pain to Germany and the entire Eurozone economy. This creates a dangerous divergence between policy and the economy: monetary policy is tightening (or remaining tight), while the economy is crying out for stimulus.

This “trap” means that the risk of policy missteps is sharply rising, and the likelihood of a “hard landing” for the Eurozone economy is also increasing. In the long run, regardless of interest rate differentials, an economy in recession will ultimately have a negative impact on the Euro.

Widening Policy Gap Between the US and Europe

This widening divergence in monetary policy paths is becoming the primary driver of the EUR/USD strength.

In a key speech on October 14th, Federal Reserve Chairman Powell explicitly pointed to “rising downside risks to employment” and “a sharp slowdown in hiring activity.” This was a significant shift in tone. He noted that despite the ongoing US government shutdown leading to a lack of official economic data, existing private sector data indicated a weakening labor market. This statement was an almost direct confirmation of market expectations that the Fed would soon cut interest rates.

Powell’s remarks significantly reinforced market expectations for further Fed rate cuts, likely at the October and December meetings. He was effectively signaling that the Fed’s focus was shifting from solely combating inflation to a more balanced strategy, with increasing attention on its employment mandate. The immediate market reaction was a corresponding decline in the Dollar Index (DXY).

A seemingly contradictory phenomenon is that the US government shutdown has actually intensified the Fed’s dovish stance, indirectly supporting the Euro. Due to the government shutdown, the Fed is unable to obtain official data on employment and inflation, leaving its decision-making like “flying blind.” In uncertain environments, central banks typically choose to act cautiously.

For a Fed already concerned about a slowing labor market, this uncertainty increases its motivation for “precautionary” rate cuts to guard against an unexpectedly sharp economic downturn. Powell’s speech confirmed this, as he relied on “existing evidence” and “private sector data” to justify his dovish stance.

Therefore, the longer the government shutdown persists, the more entrenched the Fed’s cautious/dovish stance becomes, putting pressure on the Dollar. This creates a direct but counter-intuitive positive external effect for the Euro, as the EUR/USD currency pair is primarily driven by relative policy stances. US political dysfunction is, in the short term, becoming a bullish factor for the Euro.

External Pressures and Internal Tensions

Beyond monetary policy, the Euro also faces non-monetary risks. Internal political divisions and external geopolitical threats together constitute headwinds that could undermine the Euro’s stability.

• French Fiscal Concerns: A key indicator measuring internal pressure is the spread between French 10-year government bonds (OATs) and German Bunds. This spread has recently widened to approximately 80 basis points, up from 65 basis points in the summer. The widening spread reflects market concerns about France’s fiscal situation, indicating a rising “political risk premium.” France’s budget deficit is 5.8% of GDP, almost double the EU’s 3% limit. While recent political maneuvering may have temporarily eased market panic, underlying fiscal vulnerability remains a weak point for the Euro.
• Escalating US-China Trade War: The global environment is becoming more hostile. The Trump administration is escalating its trade conflict with China ahead of an upcoming meeting with Chinese leaders during the APEC summit. US President Trump has threatened to raise tariffs on Chinese goods to 155% if no deal is reached.
• Ripple Effects on Europe: A full-blown trade war would bring tremendous uncertainty to the global economy. In such a “risk-off” environment, capital typically flows to assets perceived as safe havens, primarily the US dollar. The Euro, often used as a funding currency in carry trades, tends to underperform in this scenario. Furthermore, the highly export-dependent Eurozone economy (especially Germany) would be directly impacted by a global trade slowdown, which would exacerbate its existing economic weakness.

From a technical perspective, after reaching the Double Bottom pattern target, EURUSD retreated toward both EMAs. The price still sustains its uptrend without breaking the structure, showing potential bullish extension.

If EURUSD returns above both EMAs, the price may retest the resistance at 1.1700.

On the contrary, staying below both EMAs may lead to a retest of the support at 1.1600.

Building on the analysis above, a multi-layered outlook can be outlined.

The future path of the Euro is not a straight line, but a struggle between a clear and favorable monetary policy divergence and a deeply troubled domestic economic and political landscape.

Reasons for a bullish Euro:

• Continued dovish Fed: Persistently weak US labor and inflation data forces the Fed to deliver on its rate cut expectations, thereby weighing on the dollar.
• Resilient core inflation: Stubbornly high Eurozone services inflation forces the ECB to maintain its hawkish rhetoric and high interest rates, thereby widening the favorable interest rate differential.
• Political risks contained: France’s fiscal issues are well-managed, avoiding an uncontrolled OAT-Bund spread and preventing the outbreak of a fragmentation crisis.

Reasons for a bearish Euro:

• German economic collapse: Dire ZEW current conditions readings translate into a sharp contraction in German GDP, forcing the market to price in an eventual ECB policy reversal.
• Rising global risk aversion: An escalating US-China trade war triggers a flight to safety towards the dollar and harms the export-dependent Eurozone economy.
• Overcrowded positioning: There is a large net long speculative position in the current Euro futures market, meaning that if any bullish factors fail to materialize, the Euro will be vulnerable to a sharp sell-off, triggering a chain reaction of long liquidations.

Market analysis written by Eric Chia, Financial Markets Strategist at Exness.