European stocks and bonds have had to deal with many problems in recent years, in particular a war, an energy crisis and rising inflation. Now things are getting better. The German stock index DAX is up 14% since the beginning of November. The yield on ten-year French public debt has fallen from 3.5% in October to 2.6%. Even Italian yields have fallen below 4%, from 5% in mid-October. Investors are optimistic in part because inflation is falling faster than expected. But that mood also reflects a bleaker reality: The economy is so weak that interest rate cuts are sure to follow soon.
Will policymakers do their part? In November, inflation stood at 2.4%, very close to the 2% target of the European Central Bank (ECB). On December 13, the US Federal Reserve sent pessimistic signals. Markets now expect at least three ECB cuts between now and June, and around six in total between now and October to put the main rate around 2.5% (see Chart 1). "The most recent inflation figure has made a further rate hike quite unlikely," hawkish ECB board member Isabel Schnabel recently admitted. However, at the same time, there has been no sign of cuts; and economists expect them less than the markets. Of course, no one expected one to be decided at the December 14 meeting. With the European economy weakening rapidly, officials risk reacting slowly.
There are two reasons for concern. The first is wage growth. Initially, inflation was driven by rising energy prices and disruptions in supply chains, which drove up the price of goods. Since wage agreements are agreed for several years in the unionized European labor market, wages and prices of services have taken longer to react. On the third
quarter of 2023, German real wages fell more or less to their 2015 level. They are now recovering lost ground. Similarly, collectively negotiated wages in the Netherlands have grown by 7% in October and November, compared to the previous year, even with inflation around zero. Global wage growth in eurozone countries is around 5%.
If such growth continues, we could see a rebound in inflation in 2024, the great fear of the ECB. However, there are signs that wage increases have already begun to moderate. Indeed, a recruiting platform that tracks job ads, finds that wage growth in ads has slowed (see chart 2), indicating that wages will soon follow suit. Furthermore, wage growth does not always lead to inflation. Corporate profits, which saw a surge in 2022 when demand was high and wages low, could take a hit. There are signs that margins are shrinking.
The second cause for concern is the health of the broader economy, which has had to battle weak international demand (including from China) and high energy prices. Surveys now indicate that both industry and services are contracting gently. In some parts of Europe, the consumer boom is already fading: monetary policy itself is weighing on large debt-financed purchases and mortgage holders are reducing their spending to cope with higher monthly payments.
The decline in market interest rates should help ease the financial conditions of consumers and investors and therefore reduce the need for rapid action by ECB policymakers. However, there is a drawback. As Davide Oneglia of TS Lombard, a research firm, points out, those lower market interest rates mostly reflect falling inflation, so they don't produce lower real rates. Consequently, they are unlikely to stimulate demand.
There is one more reason for central bankers to hurry. Changes in interest rates affect the economy with a substantial delay. It takes time for higher rates to alter investment and spending decisions, subsequently leading to lower demand. The full impact of rate changes usually takes a year or more to be felt, meaning that many of the ECB's rate hikes have not yet been felt. Policymakers may have been too restrictive.
There is another side to this dynamic: rate cuts in the coming months will not affect the economy until the end of 2024, when few expect inflation to remain a problem and many do expect the economy to continue struggling. ECB policymakers will want to be close to the bloc's "neutral" interest rate (which is between 1.5 and 2%, according to Oneglia) so as not to continue putting downward pressure on demand. Starting early means the central bank could avoid having to make overly aggressive cuts during the summer of 2024.
Inflation data for January could be volatile, partly due to the phasing out of public aid plans introduced during the energy crisis. If price rises accelerate again, the ECB is likely to become even more cautious. Salary data is released with long delays in Europe, and officials are often reluctant to rely on real-time indicators, such as data published by Indeed. That's why economists don't expect rate cuts until June, much later than current market prices indicate. The ECB reacted too slowly to the rise in inflation. Now you also run that risk on the way down.
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Translation: Juan Gabriel López Guix
