Structural changes also point toward higher inflation. Obvious sources of inflationary pressure include tight labor markets (driven by aging populations); extensive investments in the energy transition, energy security, and defense; deglobalization; and the eventual costs of rebuilding Ukraine.
Currently, the annual inflation rate in the eurozone remains above 2%, and recent trends are worrisome. Looking at consumer price levels (instead of growth rates) shows that, after a slight decline in late 2023, consumer prices have accelerated in 2024, rising at an annualized pace of 3.1% so far this year (measured by the seasonally adjusted Harmonized Index of Consumer Prices).
With consumer inflation above 2% and accelerating, historically low unemployment, and rapid wage growth (negotiated wages increased by 4.7% year on year in the first quarter), initiating a rate-cut cycle now could lead to another serious policy misstep. The ECB already erred previously, in 2021-22, when it based its monetary policy on faulty forecasts, and it now seems poised to repeat the mistake. Relying on undependable forecasts and ignoring current economic realities is not a forward-looking policy; it is a hope-based one.
Forecast uncertainty presents significant challenges for all central banks, since successful policymaking requires reasonably accurate foresight. As the reliability of forecasting wanes, effective risk-management becomes crucial. Under conditions characterized by a high degree of uncertainty, monetary policy must avoid significant errors, above all.
The ECB could make either of two potential mistakes: an overly restrictive policy or a premature easing. An overly restrictive policy could cause a recession and deflation, potentially threatening the stability of financial markets or real-estate prices. While undesirable, this scenario does not pose an existential threat to the eurozone. The ECB has ample leeway, tools, and experience to combat deflation if necessary.
Conversely, premature easing could reignite inflation, forcing the ECB to reverse its initial cuts and to hike rates to higher levels than today. This scenario really could threaten the eurozone’s stability, as highly indebted member states might face unsustainable debt dynamics, with bond markets questioning their ability to repay. Central banks would then come under more pressure from governments, leading to fiscal dominance. If they are reluctant to do what is necessary, inflation could become persistent.
Persistent inflation, generated by an overly expansionary policy, is clearly the more perilous scenario. Yet this is precisely the risk that the ECB will be taking by launching a new rate-cutting cycle now. A premature shift to easing could undermine its credibility and heighten future inflation risks. By overlooking the asymmetry of risks, the ECB is exhibiting poor risk management. Central banks should not allow market pressures to dictate their policies. Premature easing is a dangerous gamble.
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About the Author
Axel A. Weber, Co-Chair of the Bretton Woods Committee Multilateral Reform Working Group, is a former chairman at UBS Group and a former president of the Deutsche Bundesbank.
FRANKFURT – With inflation in the eurozone dropping from a peak of 10.6% in October 2022 to 2.6% in May 2024, the European Central Bank is optimistic that inflationary pressures will continue to ease. Its March projections show inflation averaging 2.3% in 2024, before falling to 2% in 2025 and 1.9% in 2026. Thus, the ECB is expected to cut its key policy rate, the deposit facility rate, from 4% to around 3.75% on June 6.