The European Central Bank (ECB) recently halted its most vigorous series of interest rate hikes. Yet, as the economic landscape evolves, a new question emerges: is it time for the ECB to shift gears and consider lowering borrowing costs? Investors are eyeing the ECB’s next move as they convene in Frankfurt, with expectations leaning towards a hold on rates, despite a notable decline in eurozone inflation.
Reading the Economic Tea Leaves
The ECB’s interest rate saga has been akin to a high-stakes chess game, with each move fraught with implications. The eurozone’s inflation rate, edging closer to the ECB’s 2 percent target, poses a critical question for the governing council: have they overstepped in their efforts to curb inflation? The recent drop in inflation to 2.4 percent in November, significantly lower than anticipated, suggests that the ECB might have applied the brakes a tad too firmly.
This unexpected twist in the inflation narrative has caught the attention of economic pundits. With initial forecasts projecting inflation above 3 percent until late next year, the rapid deceleration has led some, like Krishna Guha of Evercore ISI, to suggest that the ECB might have been overly aggressive in their tightening measures. This sentiment is echoed by Deutsche Bank economists, who anticipate a downward revision of the ECB’s 2024 core inflation forecast, from 2.9 percent to a more moderate 2.1 percent.
Lorenzo Bini Smaghi, ex-ECB executive and current chair of Société Générale, points out the central bank’s pattern of underestimating inflationary trends. He cautions that the ECB might be lagging in adjusting their policies to the changing economic climate, as price pressures show signs of easing.
The Balancing Act: Rates, Growth, and Inflation
The ECB’s decision-making is akin to navigating a ship through turbulent waters. Isabel Schnabel, a prominent hawkish figure on the ECB board, has hinted at a shift in the wind. While she has steered clear of speculating about the timing of potential rate cuts, her message underscores a need for caution.
The central bank is wary of declaring an early victory over inflation, especially considering the expected uptick in December’s inflation figures due to rising German energy prices.
Frederik Ducrozet from Pictet Wealth Management views the upcoming inflation rebound as a breather for the ECB, allowing them more time to deliberate on rate cuts, possibly starting as soon as April. This cautious approach is rooted in the ECB’s previous underestimation of inflationary pressures, making them hesitant to lower rates prematurely.
One critical factor that could influence the ECB’s decision on rate cuts is wages. The eurozone has witnessed a record 6.8 percent rise in unit labor costs, the fastest since Eurostat began recording in 1995.
This increase, reflecting a combination of high wage growth and a dip in labor productivity, is a crucial indicator for the ECB. ECB President Christine Lagarde has emphasized the need for “firm evidence” that tight labor markets won’t trigger another inflationary wave.
Labor costs, especially in labor-intensive services comprising 44 percent of the eurozone inflation basket, are still on the rise. The ECB is closely monitoring collective bargaining agreements and profit margin trends to gauge whether service prices will continue to decelerate. Konstantin Veit from Pimco believes the ECB will likely indicate more work is needed to align core inflation with its target.
Apart from interest rates, the ECB’s bond-buying strategy is also in the spotlight. While most of its bond purchases have ceased, the ECB continues to reinvest proceeds from maturing securities in its substantial pandemic-era portfolio.
Several hawkish ECB members have called for an early end to these reinvestments, a topic that Lagarde has indicated will be discussed soon. However, the flexibility of focusing ECB reinvestments on countries like Italy, with high borrowing costs, remains a contentious issue.
As the ECB treads cautiously on the path of monetary policy, the question remains: will they continue to play catch-up in the inflation race, or will they find a new rhythm that harmonizes growth and stability?
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