Monetary policy at the ECB has helped stabilize eurozone inflation but there are still a few things that the economy can’t do yet. The inflation pressure has eased but the economy is still being squeezed by weak growth and outward pressures. The biggest economy in the eurozone, Germany, is a case in point, industrial output decreasing due to higher borrowing costs and a falling global demand. They’re all pieces of the puzzle policymakers will have to solve to contain inflation without damaging growth. In the European Commission’s Economic Forecast for Winter 2024, a picture of the EU’s economy is presented at large: a bleak future for the EU and the euro area. The forecasts are reduced for growth in 2024 to see the EU GDP increase only by 0.9% and the euro area by 0.8% because of tight monetary policy and weaker consumer confidence. The latter followed in the shadow of subdued economic growth of only 0.5% in both sectors in 2023. Growth should pick up a bit again at 1.7% EU and 1.5% euro zone growth by 2025. ECB inflation (another target of ECB policy) should be much lower.  EU HICP inflation is forecast to fall from 6.3% in 2023 to 3.0% in 2024 and 2.5% in 2025. This should be the same in the euro area with inflation decreasing from 5.4% in 2023 to 2.7% in 2024 and 2.2% in 2025. All of these returns have the effect of driving the monetary screws in the direction that it wants, on price stability at the expense of growth.

The 2023 decline was a combination of lower household purchasing power, low external demand and the cumulative effects of austerity measures. Fiscal repressions during the COVID-19 pandemic also came down and the economy was offered fewer protections from shocks. Exorbitant borrowing costs have held back both consumer spending and investment, especially in interest-sensitive industries like real estate and manufacturing. In Germany, these struggles are especially illustrative of regional ones. Germany is an exporting power, which means that global slowdown and geopolitical uncertainty have been particularly hurting it. Inflationary pressures of industrial output weakness are due to structural challenges, such as high energy prices and the tardiness of supply chain disruptions. The economic picture is still difficult but not hopeless. The expected decline in inflation leaves the door open for more support from policymakers in the years ahead. Inflation will ease, and ECB might ease monetary policy to encourage growth, as long as core inflation is on its way lower. Yet structural change and investment in digital and green shifts will be important for long-term resilience and competitiveness.

The monetary policy of the ECB helped to bring some considerable advances in limiting inflation, but the rest of the economy remains under pressure. The European Commission’s Winter 2024 Economic Forecast shows that there’s not a lot going to be done as growth is weak, demand is weak and borrowing is expensive, making the recovery very difficult. Those pressures will be met only by a strong coordination of policies, structural reforms and investments, and the creation of sustainable economic growth.

An article from Bloomberg reveals the diverging opinions on rate cuts. The article emphasizes the accelerating difference of opinion among officials of the European Central Bank (ECB) regarding the future trajectory of interest rates and the appropriate monetary policy. The euro-zone economy continues to progress towards its 2% inflation target and policymakers must now decide when and how to raise interest rates, communicate what they are doing, and balance the inflation outlook risks. Recent policymakers in Washington at the annual meetings of the International Monetary Fund provided a chance for ECB officials to discuss what they expect from the next phase. The path to go is now pretty much set, though rate cuts are on the horizon — though the direction and scope of those cuts is up for grabs, according to the majority of officials. Others, such as Bundesbank president Joachim Nagel and Austrian economist Robert Holzmann, called for being more conservative – perhaps a quarter-point reduction in December is more likely. Others, like the head of the Portuguese central-bank Mario Centeno, advocated incremental steps towards the economy. And it is not just over short-term rates; policymakers also differ over the outlook for inflation and the right way to communicate. Others, such as the Chief Economist of the ECB Philip Lane, insist that disinflation is in the works and recovery is simply behind schedule. Others, however, are concerned that the possibility of a big runway undershoot of the inflation target of 2% will arise, and that the ECB will take on more of a dovish posture. This policy makers’ disagreement is probably going to drive the terms they adopt for the rate path and how they express their intentions. Today’s ECB signal, albeit with the line that it will remain restrictive as long as necessary, will have to come under close examination in the coming months. This controversy will be decided by the new staff estimates for December, which include 2027 for the first time.

Another area of friction is the neutral rate – the invisible value neither driving nor stifling growth. Some policymakers don’t want to talk about this in public but others are getting out there estimating something between a bit less than 2% and up to 2.8%. Quantitative tightening (QT) will be the object of ECB officials, too. The central bank will be able to further reduce funding conditions if it continues its efforts to delist old-yielding assets from its policy holdings and defund all reinvestments this year, and it will not just be able to soften financing conditions with rate reductions but also tighten them with liquidity out of the market. This potential inconsistency has resulted in the polarization about whether QT should be kept to a minimum or rate policy must absorb any tightening that occurs. As the ECB takes this complex route, it will be important to communicate effectively in order to lead markets and keep monetary policy consistent and understandable. The central bank will have to balance out a forecast with some slack in response to evolving economic conditions. The differences of opinion between ECB officials on rate hikes, communication policy and quantitative tightening demonstrate how policymakers are working with increasingly unstable economic conditions. As the data come in and we will see how global factors like the US presidential election impact markets, the ECB would have to think more carefully about the trade-offs of risks and adjust its monetary policy accordingly.

In the end, the direction of interest rates and monetary policy in the euro-zone will depend on many variables such as inflation path, extent of economic recovery and the evolution of global risks. No one will be quite so swayed but what the ECB ultimately wants is price stability and sustainable growth in the euro-zone. With economic conditions constantly changing, policymakers and market actors will be challenged to keep up with the latest trends and to change their expectations and plans accordingly.

The ECB’s monetary policy does more than limit inflation. The economic well-being and credit markets of the region are also dependent on high interest rates. ECB’s Financial Stability Review has flagged up risk areas in commercial real estate, the most susceptible to lending rates. Higher interest rates already started to weigh on property prices and investing, which could be detrimental to the wider financial system. Personal finances were not spared such stresses. Higher mortgage rates have also added to homeowner’s debt-service costs, and higher borrowing costs have curtailed consumer consumption, which is the engine of the eurozone economy. Economic model by the European Commission predicts that continued interest rates may intensify such effects and stifle the recovery.

The ECB’s Financial Stability Review stresses the commercial real estate market’s woes: “The picture for the commercial real estate (CRE) sector has worsened, and signs of overvaluation are starting to appear in some countries”. ‘The CRE market has an especially high susceptibility to higher interest rates and softer economic growth,’ according to the report, which means that there is room for dramatic price corrections and higher default rates among CRE borrowers. Those are the points highlighted by the European Systemic Risk Board (ESRB) in its report ‘Vulnerabilities in the real estate sectors of the EEA countries’. ESRB reports “the extreme increase in interest rates and the collapse in macroeconomic conditions will likely cause a downward pressure on CRE markets” causing the possibility of increased non-performing loans and losses for banks with large CRE exposures. What does it do to household finances, when interest rates go up, is another big issue. As the European Commission’s Winter 2024 Economic Forecast puts it, “The late effect of interest rate increases will weigh on domestic demand given the persisting, albeit lower, internal and external debt-to-GDP ratios”. It’s a sentiment echoed by the Organisation for Economic Co-operation and Development (OECD) in its Economic Outlook, where they say that “higher interest rates will slow private consumption and investment” in the euro area.

The ECB Bank Lending Survey shows that the squeeze on credit for consumers and firms has not abated. It says that “banks were still indicating higher credit conditions for both corporates and homes in the last quarter of 2023”, and the level of tightening was “lower than the historical average quarterly tightening for corporate and home-buyer loans”. It means that credit tightening is continuing, but that it is slowing compared to the past three quarters. What’s more, policymakers worry about the consequences of these vulnerabilities for the financial system as a whole. According to the International Monetary Fund (IMF), in its Global Financial Stability Report: ‘The accelerating interest rate hike and the weakness in the macroeconomic picture threaten to materialize financial stability risks’ in the eurozone. It is a fact, says the report, that the financial system is such that ‘stress in one industry can quickly flow to others’, which could be even more harmful to shocks. To mitigate such risks, the ECB has been pushing for macroprudential measures as well as banks having sufficient capital and liquidity buffers. According to the ECB’s Macroprudential Bulletin, “macroprudential policies can be applied to help correct imbalances and strengthen the resilience of the financial system”, but also ‘in the context of increased uncertainty and rising interest rates macroprudential policy making is in trouble’.

Policymakers will decide whether to reign in inflation or risk financial stability and growth in this cosmic universe as the eurozone struggles with it. ECB policy on monetary policy will affect not just price stability but the financial system and its ability to re-enter recovery in the medium term. Only with good communication and coordination between monetary, fiscal and macroprudential policy will the eurozone ever weather the next storms. So mobile is the economy that policymakers and market actors will need to be fluid, pay attention to broader effects of monetary tightening and adjust.

The path forward for the ECB is filled with unknowns. Inflation is slowing, but still more than the ECB’s objective of 2% and needs to be monitored. Meanwhile, the eurozone economy needs to be nurtured vigorously to keep it going. And there is a fine line between how policymakers want to regulate inflation and tighten too much, which will aggravate economic vulnerability. A gradual monetary policy normalization might be a good alternative. That would mean remaining tight in the short term to consolidate inflation control and gradually easing towards more flexible policies when the economy strengthens. The ECB’s transparent communication will also be essential to control expectations in the markets and avoid financial instability.

This terrain can be mapped out in the ECB’s Monetary Policy Strategy Review. The review emphasizes a “medium-term orientation” of monetary policy, acknowledging that “what the correct monetary policy response should be to a deviation of inflation from target will depend on the causes, extent and persistence of the deviation”. In this way, the ECB can be flexible in its policy response to respond to changing economic circumstances while adhering to its main price stability goal. In the short term, the ECB could have to play a soft hand so that inflation doesn’t start climbing and expectations don’t drift. The longer-term inflation forecast is unchanged from 2% in the ECB’s Survey of Professional Forecasters, and the average point estimate for 2025 (in Q4 2023) is 2.1% at this rate. But the survey also says that “respondents still view the weighting of risks to inflation outlook as skewed upwards”, so caution must remain. As inflation eases and the economic recovery expands, the ECB could become gradually more dovish. It could mean a cautious interest rate cut and tweaks to the ECB’s asset purchases and forward guidance. The Winter 2024 Economic Forecast of the European Commission sees slow but steady growth in GDP for the euro area, achieving growth of 1.5% in 2025. This monetary policy normalization could allow the ECB enough room to restart the recovery. Whether and when this policy shift occurs will have to be calibrated against several different economic parameters and risk components. As stated in the ECB’s Macroprudential Bulletin, “the most important indicators should be monitored over time, including measures of credit growth, asset prices, and households’ and firms’ debt service costs” to identify accumulated fragilities in the financial system. If the ECB keeps its eye on these signs, it can tweak its policy stance when necessary to preserve liquidity and facilitate the recovery.

This will depend on clear and efficient communication in setting expectations among markets and in ensuring the ECB’s policy intentions are well communicated. The Forward Guidance and Policy Stance of the ECB emphasizes “simple, consistent and transparent communication” to support the efficacy of monetary policy. If the ECB is transparent about its policy goals, its outlook for the economy and where interest rates are headed, this will set market expectations in solid ground and lessen volatility. ECB communication might have to adjust as the economy shifts and policy demands shift. According to the European Regional Economic Outlook from the International Monetary Fund, “central banks will need to work in finely calibrated communication to keep inflation expectations well anchored and avoid overly tightening of financial conditions”. That can mean more forward-looking explanations of how interest rates are expected to move, and outlining clearly the circumstances under which they would change policy direction.

It will also require coordination with fiscal and macroprudential policies in assisting the recovery and financial stability. The Annual Report of the European Fiscal Board speaks of “a coordinated and well-structured fiscal response” in support of the recovery and of “restoring fiscal buffers and debt sustainability” in the medium term. The ECB can play an important role by cooperating closely with the fiscal authorities and macroprudential supervisors in preparing a sound and efficient policy response to the future. In this unstable environment, the eurozone will have to be open to change and the ECB must stay agile. In keeping a data-dependent posture, being transparent and coordinating closely with other policymakers, the ECB can help to lead the eurozone on a path towards an inclusive recovery that doesn’t compromise price stability or financial stability. The road isn’t necessarily easy and the ECB will certainly be faced with tough choices along the way. Yet if the ECB remains true to its mandate, carefully calibrates its policy reaction, and works in transparent and open discussions with stakeholders, it can contribute greatly to the eurozone’s recovery and sustainable prosperity.

The European economy is at a tipping point, with many different problems and opportunities. Monetary policy on the part of the European Central Bank has been a key issue in the waters of the post-pandemic recovery as it works to maintain a delicate equilibrium between a moderate rate of inflation and the encouragement of economic growth. Standardization has been a battle of compromises as policy makers struggle with core inflation and economic recovery weakness. How the ECB officials are divided over what the rate of interest should follow and what message to put out on it is a measure of the relative risks and uncertainties of the current economic climate. Some call for being a bit more conservative on rate cuts, while others say that it’s time to do something about it in order to lift the economy and avoid a prolonged downward correction. The neutral rate question and the question of quantitative tightening add more layers to the calculus of policy, so calibration is important and communication crucial. There is no discounting the wider impact of monetary tightening on financial stability and credit flows. These vulnerabilities – including in commercial real estate – and in the household finances underscore the possibility that higher interest rates will impact the rest of the economy as well. Efforts to identify and manage these risks should continue to be monitored and coordinated by policymakers using macroprudential instruments and working in close coordination with fiscal authorities for a comprehensive and effective policy response. A gradual normalization of monetary policy with a medium-term view and an eye toward flexibility would be a way to move forward for the ECB. The ECB can steer the eurozone towards a sustained recovery by being data-dependent, by speaking up clearly and communicating well with other policymakers in order to preserve price stability and financial stability.

But the road is not paved in stone. How the pandemic unfolds, how fast the global recovery proceeds and whether geopolitical and economic shocks arise from time to time also all impact the picture. The ECB will have to be agile and agile, change its policy direction and messaging as the situation shifts, and coordinate with fiscal officials and macroprudential authorities in order to provide a consistent and effective policy mix. In the end, the ECB’s success will depend on the calibrating of its monetary policy instruments as much as on whether European policymakers can deal with the structural problems of the economy, ranging from green and digital revolutions to economic resilience and inclusiveness. Through this kind of cooperation, transparency and common sense, the ECB and its partners can contribute to building a better and more sustainable future for the eurozone and its people. At this turning point for the European economy, decisions taken by policymakers in the coming months and years will have ramifications for the long-term health of the region’s economy. In tackling these risks and prospects, as the times have demanded, with knowledge, courage and the will to do our best, the ECB and its allies will make progress toward a stronger and more resilient economic future for all Europeans.

By Hongyi Gao