Manners&Willis

European life is a sweet one, from London to Paris and Berlin to Vienna you seldom find yourself in a situation not to be able to find something interesting, or even better, to buy. You dig in your pocket and find a euro, but somethings changed, it feels like it does not carry the same weight anymore. The euro has faced a myriad of challenges in recent times, reflecting the complex interplay of economic factors and policy decisions. The European Central Bank (ECB) released last month their 22nd annual review of the international role of the euro and yesterday discussed monetary policy in a meeting of the Governing Council of the European Central Bank. Let’s delve into the key challenges confronting the euro and explore the considerations policymakers must grapple with to ensure stability and sustainable growth.

One of the foremost challenges for the ECB is determining the appropriate monetary policy stance. Evaluating financing conditions, inflation outlook, underlying inflation dynamics, and monetary policy transmission are crucial considerations for this body.

Since the May monetary policy meeting, financing conditions have tightened, with past rate increases strongly affecting financial and financing conditions. However, long-term real bond yields have returned to levels seen earlier in the year. Market expectations, as embedded in forward curves and revealed in surveys, have remained relatively stable, projecting two 25 basis point rate increases for the June and July meetings.

Given the upward revision of inflation, particularly core inflation, in the June staff projections, some argue that market participants might be surprised and the forward curve could be repriced. The peak deposit facility interest rate, as reflected in the staff projections, may be deemed insufficient to bring inflation back to the 2% medium-term target. However, the staff projections also suggest interest rate cuts in the first half of 2024. Balancing the level and duration of the peak interest rate becomes crucial as policy rates approach the peak of the interest rate cycle.

The assessment of the inflation outlook reveals that inflation is projected to remain too high for an extended period. Upside risks persist, primarily due to more persistent wage-price dynamics than previously incorporated into projections. The Governing Council must stress the symmetry of its inflation objective and the undesirability of both upward and downward deviations from the 2% target. However, recent data shows that headline inflation has been on a declining path since October 2022, and confidence is strengthening that monetary policy is on the right track.

Monitoring underlying inflation is crucial, as core inflation has been revised upward significantly. Strong wage growth is increasingly driving inflation, and evidence of a peak in underlying inflation remains uncertain. Core inflation, while not directly representative of the household consumption basket, still influences future headline inflation in the eurozone.

Achieving effective monetary policy transmission poses challenges across eurozone countries. Differences in institutional arrangements, fiscal policies, and other national factors result in varied impacts of interest rate increases on financing conditions, credit volumes, and the real economy. The effects of past rate hikes are expected to materialise, potentially exerting a downward impact on growth and inflation. Additionally, uncertainty surrounding the transmission of monetary policy is highlighted by substantial differences in estimated effects across models.