Will the European Central Bank change its direction due to inflation?

The European Central Bank only halted its boldest series of interest rate hikes ever last October. But pressure is mounting from investors to start reducing borrowing costs.

When the European Central Bank’s Governing Council meets in Frankfurt on Thursday, it is expected to leave interest rates unchanged, even though inflation in the euro zone is very close to its 2 percent target.

Instead of considering easing its policy, the central bank is preparing to respond to market bets on a cut as early as March by signaling that it still sees upside risks to prices, especially from rising wages, the Financial Times notes. » In her report.

With official forecasts for growth and inflation in the euro zone expected to be lowered and investors awaiting any clues about when interest rates might be cut, these are the key questions for the ECB:

Are interest rate setters lagging behind the disinflation curve?

Inflation in the euro zone has slowed throughout 2023 as energy prices retreat from the rise seen last year due to Russia’s war on Ukraine. However, ECB policymakers continued to warn of the risk of price growth remaining above its 2 percent target.

However, this scenario of the “last mile” of disinflation being the hardest looks much less likely after eurozone inflation fell to 2.4 per cent in November – much lower than expected and tantalizingly close to target. .

Given the European Central Bank’s forecast in September that inflation would remain above 3 percent until the fourth quarter of next year, monetary policymakers appear to have underestimated the pace of inflation decline.

Economists at Deutsche Bank expect the European Central Bank, on Thursday, to lower its forecast for core inflation for 2024 – which excludes energy and food to give a better picture of underlying price pressures – from 2.9 percent to 2.1 percent.

The Financial Times quoted Lorenzo Bini Smaghi, a former executive director of the European Central Bank who now heads the French bank Société Générale, that after significantly underestimating the rise in inflation last year, central bankers “may again be late in… adjust their policies” as price pressures fade.

Is the market right that interest rate cuts are imminent?

Isabel Schnabel, the most hawkish member of the European Central Bank’s governing council, noted last week that the “encouraging” decline in inflation had shifted sentiment among policymakers by repeating a quote often attributed to John Maynard Keynes: “When the facts change, I change my mind.” What are you doing, sir?

But the only tangible change in Schnabel’s position is that she no longer believes that raising interest rates is still a realistic possibility. She was careful not to discuss the timing of the cuts and stressed that the central bank should be more cautious than the market. “We still need to see more progress on core inflation,” she said. “We must not declare victory over inflation prematurely.”

Inflation is expected to rise again to nearly 3 percent in December, as German energy prices will rise compared to last year when the government paid gas and electricity bills for most households, according to the Bundesbank.

“This recovery in inflation will give the European Central Bank some breathing room before it needs to cut,” said Frederic Ducrozet, head of macroeconomic research at Pictet Wealth Management, adding that he believes interest rate cuts could begin in April. He added, according to the Financial Times report: “After their failure to estimate the rise in inflation two years ago, it is natural for them to hesitate to declare victory too early.”

– What could prevent interest rate cuts in March?

Wages are the biggest factor. Unit labor costs per hour worked in the euro area rose 6.8 percent in the third quarter from a year earlier, the fastest pace since Eurostat began recording in 1995.

Daniele Vernazza, an economist at the Italian UniCredit bank, said that this rise reflects “a decline in labor productivity, strong employment, weak production, and high wage growth.”

European Central Bank President Christine Lagarde said last month that she still wants to see “conclusive evidence” that tight labor markets are not causing another rise in inflation.

Wages are a major input into the prices of labor-intensive services, which constitute 44 percent of the inflation basket in the euro area, and are still rising at an annual rate of 4 percent. The ECB will want to see the results of collective bargaining agreements with unions in early 2024 and increase pressure on profit margins to judge whether service prices will continue to slow.

Will the European Central Bank stop buying bonds early?

The European Central Bank ended much of its bond buying last year. But he is still reinvesting the proceeds of outstanding securities in the $1.7 trillion portfolio he began buying in response to the pandemic. He has made plans to continue these reinvestments until at least the end of next year, which would entail purchasing about $180 billion in bonds in 2024.

Many of the more hawkish members of the European Central Bank have called for an early end to these reinvestments. Lagarde said last month that the matter would be discussed “in the not too distant future” and many observers expect the reduction in purchases to begin as early as April.

Schnabel said it doesn’t seem like a “big deal” because these purchases will expire anyway and the amounts are “relatively small.”

But some policymakers say the flexibility to focus the ECB’s reinvestment on any country is useful to counter a potential increase in borrowing costs for a heavily indebted country like Italy.