Interest rates in Europe
The latest HICP flash estimate for February 2024, that was published by Eurostat on Friday 1st March, indicates that the headline annual HICP based inflation rate now stands at 2.6%.
Some had expected a deeper drop. However as we are slowly edging closer towards the 2% target that the ECB has repeatedly outlined, the international financial press gets filled with articles pushing for interest rate cuts. The debate is whether the ECB will actually announce any interest rate cuts in 2024. In my humble opinion, I believe it is too early to say whether this will happen and I will explain why.
As the ECB has remarked various times, before taking any loosening monetary policy decision they need to be convinced that inflationary pressures have really eased across the board and well deep below the bonnet. Hence, they will not be looking only at the headline inflation rates. At deeper look at the flash estimate for February 2024, shows a persistent high services inflation as services prices rose 3.9% in February 2024, only a slight dip from consecutive 4% rises in each of the previous three months. Moreover, while the Annual rate has dropped to an increase of 2.6% (from 2.8% the previous month), HICP based inflation on a month-on-month basis within the Eurozone has risen by 0.6%, which was the fastest pace since April 2023.
Within this context I believe the ECB will be cautious as to when to implement any rate cuts and will surely be deeply data driven in their decisions. The greatest risk lies in the socalled rapid wage growth which may keep prices rising too fast in the labour-intensive services sector, which is especially important in Europe, as it accounts for 45% of all prices used to calculate inflation.
The good news in previous weeks was that annual rises in collectively negotiated wages, which cover the majority of eurozone workers, slowed from a record high of 4.7% in Q3 2023 to 4.5% top Q4 2024. Having said so, this is still well above the 3% level the ECB says is needed for inflation to hit its 2% target. So in my view, beyond the headline inflation, the ECB will be closely watching trends in wage growth and service inflation very closely and would need to be convinced that inflation coming from the labour market has eased substantially before taking any decision to reduce interest rates. In my opinion what would tip the balance is data indicating that the labour market is deteriorating sharply, with rising unemployment and the prospect for business insolvencies. This would then likely prompt the ECB to be proactive in cutting interest rates and in that case it would likely do so aggressively.
Obviously, the ECB is also facing the usual political pressure. Some European politicians are already calling for the ECB to do more to support the euro area’s struggling economy, which flatlined in the fourth quarter after stagnating for much of last year. The Italian and Portuguese finance ministers both appealed for a swift reduction in borrowing costs during the recent G20 meetings in São Paulo. They are obviously also concerned with the risk that high interest rates bring on their rolling over efforts of their extensive public debt. European politicians have also to realise that their push for carbon taxes and for more favourable working conditions are ultimately also contributing for more cost-push inflation, which is not easily controlled by monetary policy, the way demand-pull inflation is. This in turn could make the attainment of the 2% inflation target more difficult to achieve.
One has to remember that the ECB was widely criticised for being too slow to start raising rates in response to the big surge in inflation in 2022. So now the ECB will likely be determined to take its time before loosening monetary policy to avoid being in the line of fire once more. Only time will tell.
“European politicians have also to realise that their push for carbon taxes and for more favourable working conditions are ultimately also contributing for more costpush inflation, which is not easily controlled by monetary policy, the way demand-pull inflation is.”