Daily Management Review

Falling Inflation In The Euro Zone Puts The ECB At Odds With Markets


Falling Inflation In The Euro Zone Puts The ECB At Odds With Markets
For the third consecutive month, euro zone inflation fell faster than anticipated in November, undermining the European Central Bank's thesis that price increase is unyielding and encouraging betting on early spring rate cuts against the bank's stated instructions.
A year ago, inflation was around 10%, but it has now rapidly decreased to the ECB's 2% objective, although officials have issued a warning against becoming overly optimistic. They caution that recovering below 3% of GDP may prove to be more challenging in the "last mile" of deflation.
Although a recovery in the upcoming months is still likely as high energy prices are subtracted from year-earlier results and some tax cuts are undone, hard data indicating inflation decreasing more faster than anticipated seems to be undermining that prediction.
With the exception of unprocessed food costs, consumer price rise in the 20 countries that share the euro fell to 2.4% in November from 2.9% in October, significantly below estimates for 2.7%.
Even the fundamental pricing pressures subsided faster than anticipated, with the ECB's widely watched inflation rate, which excludes food and energy, falling to 3.6% from 4.2% due to a significant decline in service prices.
The sharp decline in inflation puts investors and the euro zone central bank at odds because they both seem to be pointing in quite opposite directions for future ECB interest rates and consumer prices.
"With a third month of an unambiguously good inflation report, and with prices actually declining from the previous month, it is starting to look that before long we will be talking about inflation being too low, rather than too high," Kamil Kovar, a senior economist at Moody's Analytics, said.
"And if the recent trends in inflation and growth continue then 2024 will be the year when the ECB implements a pirouette in monetary policy."
The European Central Bank (ECB) contends that underlying dynamics are more resilient than they seem and that inflation will rise above 3% in the upcoming year, only reaching the 2% objective in late 2025, in part because of a sharp increase in nominal wages.
Because of this, the bank will have to maintain its record-high deposit rate of 4% for a considerable amount of time. Not even Yannis Stournaras, the dovish head of the Greek central bank, anticipates a reduction before mid-2024.
This argument would seem to be supported by new statistics released on Thursday, which highlights how tight the labour market is in the euro zone and shows that unemployment is holding at a record-low 6.5% despite an economic recession.
While without directly criticising the ECB's guidelines on Thursday, Bank of Italy Governor Fabio Panetta did issue a warning about the risks associated with maintaining high interest rates for an extended period of time.
"The duration of this phase will depend on development in macroeconomic variables; it could be short if continued weakness in economic activity accelerates the decline in inflation," Panetta, a former ECB board member, said. ""We need to avoid unnecessary damage to economic activity."
Investors are pricing in a total of 115 basis points of rate cuts for the upcoming year, with a first move by April completely factored in, despite ECB President Christine Lagarde's explicit guidance for stable rates for several quarters being ignored more and more.
The ECB's own forecasts have a dismal track record, which is a major contributing factor to the disparity. It has been compelled to rescind its recommendations on multiple occasions in the last few years after initially raising doubts about market expectations.
The job market is deteriorating, loan demand has vanished, and growth is less than the ECB predicted, according to economists, all of which lead to a rapid disinflation.
"Also, there is still a lot more of the impact of tightening to come as interest payments are still increasing," ING economist Bert Colijn said. "The market is therefore right to start looking at rate cuts for 2024. We think the first one could well happen before the summer."
Some economists contend that, unlike in typical periods of high inflation, corporate profits—rather than wages—are the primary driver of the current inflation, making it extremely challenging to model.