Alan Greenspan, former chairman of the Federal Reserve, once warned against fear and euphoria. Mainly because these two forces could not be captured by economic models. Central banks are facing the last mile in the fight against rising prices, trying to escape these two sensations: they do not want to claim victory or be carried away by fears of recession. However, markets are already beginning to expect that the rapid decline in inflation, particularly in Europe, and the entry into a period of anemic growth will force the Federal Reserve and the European Central Bank (ECB) to cut interest rates. earlier than expected, even from spring 2024. Experts also warn that the ECB could ignore the speed of price declines, which could put more strain on the euro zone economy than necessary.
“When the facts change, I change my mind.” Isabel Schnabel, a member of the ECB's most orthodox wing, used Keynes to explain her most optimistic vision for the fight against inflation in an interview with Bloomberg, which was announced in November throughout the year Eurozone was 2.4%. The German found it a “very pleasant surprise”. And this language change solidified markets' belief that interest rates will fall to as much as 2.5% in 2024. Investors therefore assume that the much-feared last mile to reach the 2% inflation target will not be as costly as assumed.
After the Federal Reserve released its 2024 interest rate cut forecast, Frankfurt tried to stop the euphoria that Greenspan found so damaging. ECB President Christine Lagarde claimed on Thursday that the council had never discussed interest rate cuts. “It's like the solid, liquid and gaseous states: you don't go from the solid to the gaseous state without going through the liquid phase,” said the Frenchwoman. The markets initially calmed down, but even in this sentence they recognized Lagarde's calculated ambiguity: bodies can go from solid to gas through sublimation. On Friday, debt markets fell again – Spanish debt stood at 3%, down one point from two months ago – and Euribor continued its downward trend, giving governments and families breathing room.
The incoming data confirms investors' forecasts. International organizations consider Europe to be the most lagging economic bloc, with Germany and France lagging behind; Salaries are still far from making up for lost purchasing power and energy costs continue to fall despite the war in Ukraine. In fact, Frankfurt lowered its growth forecasts for the Eurozone in 2023 and 2024. “Slowly [el BCE] lays the foundation for future interest rate cuts. Specifically, we expect this to begin in June 2024, although this could also happen earlier, in March, given the risks to the growth outlook and the possibility that disinflation will continue rapidly,” says Nadia Gharbi, economist at manager Pictet WM.
It's not just Schnabel who has made a significant change in tone. Some members of the Council, such as French Governor François Villeroy de Galhau, stated in La Dépêche du Midi that the process of “disinflation is progressing faster” than they believed. “Except for shocks, there will be no new interest rate hike. The question of a rate cut may arise in 2024, but not now,” he added. In a bid to curb market speculation, Slovakia's Central Bank Governor Peter Kažimír stated via his Twitter account that while the data suggests that no further adjustments will be needed, a cut in the first quarter of 2024 is “science fiction.” However, markets never expected reductions at the start of the year.
Experts believe that the ECB may be lagging behind what is happening in the real economy. “In 2020 and 2021, we criticized the temporal theory of central banks as they stated that they should remain inactive because inflation would rise and fall on its own. In late 2021 or early 2022, they gave up and started raising rates just as inflation peaked. Since then, inflation has fallen steadily, long before interest rate increases had an effect,” criticizes Charles Wyplosz from the Graduate Institute of Geneva.
Risk of forecast errors
“Disinflation is progressing faster than most economists predicted,” agrees Paul De Grauwe, a professor at the London School of Economics. “The ECB underestimates the speed of the current disinflation. There is little evidence to suggest that the last mile is the most difficult. The ECB is making the same mistake now as it did when inflation rose. “Back then, people underestimated the speed of the rise in inflation, today they underestimate the speed of the decline,” emphasizes the economist.
The main problem is that the heavy hand of the Eurobank can further depress the economy. The focus remains on a soft landing. “The inflation we are experiencing now will disappear without the need for a recession. A recession would actually be a failure of central banks,” says De Grauwe. Wyplosz also regrets that the ECB will end up giving in to the markets as it would be a blow to its credibility. “Monetary policy is now devastating, just as inflation approaches the 2 percent target. If this view is correct, inflation will continue to fall while growth stagnates. “Central banks will have to go back to what they have said so far and cut interest rates quickly,” he claims.
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