ECB and markets at odds over Eurozone inflation forecasts and timing of rate cuts
Analysts expect inflation to fall more sharply than the ECB. Assessments diverge on wages, margins, GDP and domestic price pressures. The impact of the Bundesbank's projections and the effect on rates
In spite of the attempt by many ECB board members to dismiss market expectations of a close and significant rate cut in 2024, analysts' forecasts have not moved much: traders continue to see a 50-60% probability of a reduction in March, and some already imagine two by April. If anything, the expectation for the total cuts in 2024 has changed, but in the opposite direction: the markets are now discounting almost seven cuts, more than the six predicted in recent days, with a total reduction of 165 basis points instead of 150.
Yet President Christine Lagarde has recalled in recent days that 'in the first half of 2024' important economic data on wages will be published, with the implicit aim of shifting expectations of a cut to June-July. Bundesbank President Joachim Nagel explicitly warned markets against expectations of imminent cuts, while French Governor Villeroy De Galhau spoke, albeit cautiously, of a possible rate cut 'at some point in 2024'.
The divergence between market expectations and the ECB's caution is explained by a very different assessment of inflation and the economy. The ECB still sees upside risks on inflation, despite the fact that it fell to 2.4 per cent in the Eurozone in November, thus close to the 2 per cent target. Economists have already factored in a temporary rise in inflation in December (estimates range from 2.9 to 3.1 per cent) as a consequence of non-structural statistical effects. But the ECB fears instead a rise in wages and an increase in 'domestic' inflation next year.
The divergence on 'domestic' inflation
The concept, which has left doubts among economists, was highlighted by Lagarde: "There is one measure of core inflation that is falling a little bit, but not much, and that is domestic inflation, which is largely driven by wages. We need to better understand why domestic inflation is holding up'. This fear is the basis for the ECB's caution on inflation and thus on rates. But Barclays replicated ECB's methodology and noted that 'the dynamics of domestic inflation have slowed significantly, implying a likely further decline'. Moreover, for the British bank's economists there is 'limited evidence' that domestic inflation is driven by wages, while the opposite is more likely.
The different outlook on inflation
There is no economic certainty about the ECB hypothesis. In general, market analysts believe that inflation in the Eurozone will fall faster than the Eurosystem's estimates (2.7 % in 2024, 2.1 % in 2025 and 1.9 % in 2026). As for next year, Barclays forecasts a figure of 2.4 %. Unicredit lowered its estimate to 2.3% due to 'a lower starting point as a result of the downward surprise in the latest data, lower oil prices and lower than expected increases in electricity and gas bills early next year'. Unicredit's forecast for 2025 is 1.8 per cent in the Eurozone, thus below the ECB's target, which risks missing the mandate's target due to excessive prudence. An even bigger problem considering that the ECB target is symmetric, so it should consider upside risks on inflation in the same way as downside risks.
Citi says inflation will be below 2 per cent in 2025, at 1.7 per cent. According to the US bank's economists, weak consumption will limit the ability of companies to set higher prices, unlike in the past. Companies will absorb wage increases without passing them on to end customers. Moreover, for Citi, wage-related inflation peaked in mid-2023 and will fall in 2024, while energy prices will rise 'modestly'. Therefore, according to the bank, the 'last mile' on inflation theorised by German board member Isabe Schnabel may turn out to be 'the last metre'. Citi thus considers the Eurosystem's inflation estimates to be hawkish even after the recent downgrade (from 3.2 to 2.7 per cent for next year).
The impact of the Bundesbank estimates
The December projections, as is the case every six months, were compiled by the Frankfurt staff with the national central banks of the Eurosystem. The Eurozone figure was mainly influenced by that of the Bundesbank: Germany is the only one among the large European countries not to reach 2 per cent in 2025. Berlin, according to the national central bank, will not reach the figure even in 2026, when inflation will still be at 2.2 per cent. The Bundesbank thus indicated forecasts that deviate from those of other national institutes. The estimates were motivated by 'strong' wage growth and a recovery in consumption. At the moment, however, Germany is the country with the weakest economy and could suffer from the budget tightening imposed by the debt brake, especially after the recent ruling of the German Constitutional Court.
Recession is approaching
Weakness in the economy is another factor that could push inflation lower than expected. The ECB expects a pick-up in demand, which according to Schnabel must be 'dampened'. But activity is weak in the Eurozone: the area is on the verge of recession. The PMI indices and the latest data on industrial production and credit point in this direction. Moreover, all states will have to put their public accounts in order, which will have a further restrictive effect. Many economists therefore see no reason for significant inflationary pressures and point out that the ECB has so far underestimated disinflation. The coming months (and the new projections in March) will tell whether the central bank was right to side against analysts' expectations. One thing is certain: someone is wrong, either the markets or the ECB.
