The eurozone economy is stagnating, price growth is slowing and high borrowing costs are squeezing demand for loans, yet the European Central Bank is expected to say this week it needs more time to be sure inflation has been tamed.
Bank-watchers are confident its rate-setters, led by president Christine Lagarde, will leave monetary policy on hold — with the deposit rate at a record high of 4 per cent and its vast bond portfolio slowly shrinking — after the governing council meets in Frankfurt on Thursday.
The ECB will be the second major bank to meet on policy since the start of 2024, after the Bank of Japan kept rates in negative territory on Tuesday. The eurozone bank looks likely to set a cautiously optimistic tone in the fight against inflation, which has fallen from a peak of 10.6 per cent in late 2022 to 2.9 per cent last month, ahead of meetings by the US Federal Reserve and Bank of England a week later.
Economists will watch for signs of how fast the ECB expects inflation to keep decelerating and how soon it and other central banks will start to cut interest rates later this year.
For now, most eurozone rate-setters seem confident they are on track to bring inflation down to their 2 per cent target by next year. But many want more evidence that the upside risks such as strong wage growth are not going to materialise before they are ready to declare victory — a message Lagarde is expected to emphasise at her press conference on Thursday.
Katharine Neiss, a former BoE economist now at investor PGIM Fixed Income, said the second quarter was the “earliest period in the frame for cuts” in eurozone rates, especially after policymakers were criticised for underestimating how high inflation would surge.
“Put simply, it’s a case of once bitten, twice shy and policymakers will want to be sure that the inflation genie has been put firmly back in the bottle,” she added.
There are several reasons why Lagarde is likely to remain cautious about the pace of disinflation. The ECB’s primary concern is that in a tight labour market — euro area unemployment is at a record low of 6.4 per cent — workers will demand big pay rises to restore the purchasing power they lost after the largest price surge for a generation. Coupled with falling productivity, this risks pushing up price pressures again as companies try to pass on their higher labour costs.
Eurozone wages rose 5.3 per cent in the year to the third quarter of 2023, accelerating from 2.2 per cent a year earlier. There are some signs this could keep rising, judging by a union demand for a €500-per-month wage increase for Germany’s almost 1mn construction workers — equivalent to a 21 per cent pay rise for the sector’s lowest-paid majority.
Construction workers in Germany, the eurozone’s largest economy, had their last wage negotiation in 2021, before inflation started surging, so their latest demand reflects a desire to catch-up with the higher cost of living. The country also has widespread shortages of construction workers, strengthening their negotiating position.
Boris Vujčić, governor of the Croatian central bank and one of the newest members of the ECB council, said this month: “We will definitely want to see the first-quarter wage negotiations [to decide] where wages will settle.”
Data on first-quarter eurozone wage growth will be published shortly after the ECB’s meeting in April, pointing to the summer as the earliest moment rates could be cut. Philip Lane, ECB chief economist, said recently: “By our June meeting, we will have those important data.”
The other upside risk on inflation is the war between Israel and Hamas and the potential for it to escalate into a wider Middle East conflict that could disrupt energy supplies from the region and send oil and gas prices higher.
Attacks by Yemen’s Houthi rebels on ships in the Red Sea have already disrupted global trade, causing many vessels to travel round the southern tip of Africa rather than risk going through the Suez Canal, adding time and cost to goods transport.
However, most economists downplay the inflationary impact of the maritime disruption. Mark Wall, chief European economist at Deutsche Bank, said there was “a buffer to absorb rising costs” thanks to spare capacity in the shipping industry, high inventories, elevated profit margins and weak demand.
Oil prices have fallen since the Israel-Hamas conflict started and European natural gas prices have almost halved in the past three months to drop to their lowest level for more than two years.
In addition, the eurozone economy is expected to remain weak, with Barclays forecasting gross domestic product will contract 0.1 per cent in the fourth quarter from the previous three months, helping to cool price pressures.
Banks continued to tighten lending standards in the final three months of 2023 and said they expected to squeeze credit supply further at the start of this year, according to an ECB survey of lenders published on Tuesday. The banks also reported lower borrowing demand from households and businesses, but said they expected a small rebound at the start of 2024.
“We do think policymakers recognise that eurozone economic weakness is proving to be extended and likely has more to run in services, even though the manufacturing side may be stabilising at weak levels,” said Krishna Guha, a former Fed official now at US investment bank Evercore ISI.
Consumer price growth has undershot ECB forecasts for two months, despite picking up to 2.9 per cent in December. UBS economist Anna Titareva forecast it would slow again to 2.8 per cent in January as “falling goods inflation” more than offset higher services inflation caused by an increase in VAT on German restaurant meals.
Investors are betting that faster-than-forecast disinflation will push the ECB to start cutting rates as early as April, with swaps markets pricing in 1.35 percentage points of cuts this year. But a string of ECB policymakers have signalled recently that this looks too optimistic. Lagarde told last week’s World Economic Forum in Davos that a rate cut “is likely” by the summer.
While most economists think the ECB will start loosening policy by cutting rates by a quarter of a percentage point, some think being behind the curve could force it to cut by a more aggressive half-point.
“A later start with rate cuts would raise the probability that the council would need to catch up with a couple of 50 basis-point moves during the summer,” said Sven Jari Stehn, Goldman Sachs’ chief European economist.
