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Economists have warned that the European Central Bank faces the threat of inflation that is too low rather than too high as the euro zone's economic growth slows and consumer price rises slow. There is.
The prospect of lower price rises is a sharp turnaround from recent historically high inflation levels that forced the ECB to raise interest rates to a record 4% in September 2023.
Monetary policy makers are widely expected to meet this Thursday and cut interest rates. Investors now see a quarter-point rate cut to 3.25% as a given, although they had previously not expected a rate cut until December.
Economists said October's rate cut could begin a series of faster and deeper cuts to borrowing costs to prevent inflation from falling sustainably below target. Financial markets are currently pricing in the ECB to cut interest rates to just 1.7% by the second half of next year. Annual inflation fell to 1.8% in September, falling below the ECB's medium-term target of 2% for the first time in more than three years.
“To avoid a return to the pre-corona world” [of inflation below 2 per cent] This will be one of the biggest challenges for the ECB,” said Jens Eisenschmidt, chief European economist at Morgan Stanley, who worked at the ECB until 2022. He expects the ECB's main deposit facility rate to halve to 1.75% by December 2025, but added: “It is very likely that this level is not the end.” [of the easing cycle]”
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Historically, the ECB's bigger problem has been that inflation is too low rather than too high. Inflation was below the ECB's target in 93 of the 120 months to July 2021, when the latest price spike began as demand recovered during the pandemic. The 2% target was introduced that summer.
This replaced inflation with a more conservative target of “less than but close to 2%.” To prevent further declines in inflation, the ECB has embarked on unconventional monetary policy, inflating its balance sheet through bond purchases and pushing key interest rates into negative territory.
Minimal price increases increase the risk of falling into deflationary territory, potentially triggering a self-reinforcing downward cycle as consumers postpone purchases while lower incomes make it harder to service debt. For central banks, overcoming deflation can be much more difficult than controlling inflation.
So far, the ECB staff's latest forecast is that annual inflation is expected to reach its 2% target in the fourth quarter of 2025 and remain well above that level for the first nine months of this year.
But central bank officials were concerned that the outlook, released in September, was too rosy even before the 1.8% annual inflation figure was released that month. According to the minutes of the September meeting, rate setters noted that “the risk of falling short of target has become impossible to ignore.''
Bank of Greece Governor Yanis Stournaras said this week that the latest data “suggests that we will probably reach 2% in the first quarter of 2025.”
This is despite headline numbers expected to temporarily increase by the end of the year. Because oil prices temporarily fell at the end of last year, the year-on-year comparisons for November and December will be skewed upward due to statistical peculiarities.
But Bill Divigny, head of macro research at ABN AMRO, said the ECB would “see through it”.
Headline inflation is also expected to be higher next year than weaker fundamental economic dynamics would suggest, as wage increases in major euro zone countries respond with a lag to past inflation spikes, the report said. said a person familiar with member countries' thinking. of the Governing Council.
“In the short term, the weaker growth outlook is the more important factor, but there is also the risk of undershoot.” [the 2 per cent inflation target] It’s already part of the equation,” the official said.
ECB President Christine Lagarde said last week that the central bank would take into account growing confidence that the bank's medium-term inflation target is within reach, raising investors' hopes for a rate cut.
But Sebastian Durien, research director at the Düsseldorf-based Institute for Macroeconomic Policy, said the slowdown in economic growth and sharp decline in inflation suggested the ECB was “acting too late.” Ta. [on adjusting rates] Once again,” he said, adding that the central bank's analysis of inflation factors was “flawed”.
Durien argued that the inflation spike between 2021 and 2023 was not due to an underlying increase in demand, but rather was a temporary phenomenon caused by soaring energy prices and supply chain bottlenecks. He said the ECB had raised interest rates too much, hurting an economy already battered by low productivity, weak investment and an aging population.
“Overly restrictive monetary policy has exacerbated some of the structural problems,” Durien added.
