Since July 2022, the European Central Bank (ECB) has faced the eurozone with interest rate increases of unprecedented scale and speed. The effects of this policy are now beginning to appear.
The Organization for Economic Co-operation and Development expects eurozone gross domestic product (GDP) to grow by just 0.6% this year, revised down from 0.5% in 2023. This is the weakest growth performance among major countries.
Gross fixed capital formation (investment) will be hit the hardest, falling by 0.6% in 2024. The ECB expects growth to accelerate in 2025 (+1.6%). But this was also the company's 2024 prediction a year ago.
The tight monetary policy associated with high interest rates is further reinforced by restrained fiscal policy. The ECB has confirmed that the withdrawal of some support measures to combat rising energy costs and inflation will lead to a tightening of the euro area's fiscal stance in 2023, as reflected in the (economically adjusted) primary balance. We estimate that there will be further significant tightening in 2024. The strain on fiscal policy in the euro area is evident when comparing the 2024 budget deficit of 2.9% of GDP with the US budget deficit, which is expected to reach 5.3%, according to the Congressional Budget Office.
Another sign of the lack of dynamism in the euro area is the stagnation in bank lending to the private sector since autumn 2022.
This poor economic performance is reflected in a faster-than-expected rise in inflation. As of September 2023, ECB staff's 2024 inflation forecast was 3.0%. This month, the forecast was revised downward to 2.3%, closer to the target. For 2025, the inflation forecast of 2.0% is fully on target.
Another sign of the lack of dynamism in the euro area is the stagnation in bank lending to the private sector since autumn 2022. As a result, the growth rate of M3 (a standard measure of money supply) has slowed sharply and is currently close to zero.
change of seasons
Considering that the effects of monetary policy are not immediate but are delayed by about 1-2 years, we conclude that disinflation has been successfully achieved and that it is time to move from restrictive to neutral policies. can do. However, ECB President Christine Lagarde takes a different view. When asked by a journalist about the merits of gradual rate cuts, she responded with an elegant but somewhat confusing analogy: “I liken it to seasons and episodes.” The event is still in progress. We are now moving into a restricted season, but that will take some time. And once that season is over, we will move into the normalization season. ” This suggests that “normalization” is still far away.
How does Lagarde justify this policy stance? On a general level, he continued to stress that the ECB is “taking a data-driven approach to determining the appropriate level and duration of restrictions.” But this is not very straightforward, as no one expects the ECB to make decisions based on “data”.independent attitude.
Also revealing was his reference to three elements of the ECB's “reaction function”: the inflation outlook, underlying inflation, and the strength of monetary policy.
As far as the inflation outlook is concerned, some would argue that an inflation rate of 2.3% in 2024 and 2.0% in 2025 would justify “normalization”. Given the range of uncertainty surrounding the ECB's inflation forecasts, it cannot be ruled out that “headline” inflation could fall below 2% as early as the third quarter of 2024 (lower bound). are 60% and 30%). But the president is not satisfied yet: “I wish everything was closer to the goal.'' We're not there yet. we are not there. He still expects headline inflation to be 2.3%, a revision from his previous forecast. But in 2024 he's still 2.3%, and in 2025 he's still 2%. ”
The main measure of underlying inflation is “core” inflation, which excludes energy and food prices.
The insistence on achieving targets to the decimal point is difficult to reconcile with the ECB's strategy, which insists that “the Governing Council confirms the medium-term direction of the monetary policy strategy.” This takes into account the inevitable short-term deviations of inflation from target, as well as delays and uncertainties in the transmission of monetary policy to the economy and inflation. ”
Indeed, the strategy sees an advantage in this flexibility in the medium-term direction, which “enables the Board to respond in monetary policy decisions to other considerations related to the pursuit of price stability.” ing. For example, it may be possible to take into account the negative side effects of bank interest rate policy on economic growth, namely the cost of overly ambitious inflation control.
The main measure of underlying inflation is “core” inflation, which excludes energy and food prices. It's still 3.0%, but in our experience this indicator lags headline (technically his HICP) inflation and is therefore not a good guide from a forward-looking perspective. The focus on core inflation may explain why the ECB waited until July 2022 to raise interest rates, even though headline inflation had already reached high levels in autumn 2021.
natural rate of interest on capital
Regarding underlying inflation, the ECB is paying close attention to wage developments in the euro area. Indicators of employee-negotiated wages and compensation suggest that a tipping point has been reached. Moreover, inflation expectations are particularly important for future wage trends.
The median inflation expectation three years from now is 2.5%, not significantly different from the ECB's inflation target.
The ECB is likely to cut its key policy rate in June, but the big question is how quickly and to what extent. To answer that, we need to assess the euro area's neutral interest rate. The concept of a neutral interest rate dates back to Knut Wicksell (1851-1926). He explained: “There is a fixed interest rate on a loan that is neutral with respect to commodity prices and does not tend to raise or lower prices.” This is necessarily the same as the interest rate determined by supply and demand if money were not used and all lending was affected in the form of real capital goods. Describing it as the present value of the natural rate of interest on capital amounts to much the same thing. ”
It took less than a year for the ECB to raise the policy rate from 2.0% (December 2022) to 4.0% (September 2023). Why can't it be reduced at the same rate?
There is much debate about the theoretical concepts and results of empirical studies for measuring natural speed. A recent study by the ECB concluded that “estimates obtained from term-structured and semi-structured models ranged from about minus three-quarters of a percentage point to about half a percentage point.” Therefore, we can say that the euro's neutral or natural real interest rate is close to zero. If the inflation rate reaches the 2% target, the neutral nominal interest rate will also be 2%.
“Normalization” therefore requires lowering the ECB's policy interest rate to 2%. Given the state of the eurozone economy, it would be wise to achieve this process in a symmetrical manner, rather than the gradual “three-season” approach envisaged by Lagarde. It took less than a year for the ECB to raise the policy rate from 2.0% (December 2022) to 4.0% (September 2023). Why can't it be reduced at the same rate?
The euro area faces a difficult transformation process due to climate change, digital innovation and competitors such as China and the United States that are not bound by fiscal rules. “Normal” interest rates are a key prerequisite for financing the huge investments needed to achieve this transformation.
This is a joint publication by. social europe and IPS Journal.
