The governing council of the European Central Bank (ECB) lowered interest rates again in October. The bank expects annual inflation in 2026 to reach 1.9 percent, which would align with the ECB’s target of 2 percent annual price increases.
In December 2021, prices in the eurozone were 5 percent higher than a year earlier, 2.5 times higher than the ECB’s target. At that time, the bank’s message was: we don’t need to raise interest rates; our forecasts show that inflation in the currency union will be 1.8 percent in 2023. Sleep well, we are guarding the value of your money. In 2023, inflation in the eurozone reached 2.9 percent, considerably above the target.
Price increases accelerated in 2022 to over 10 percent, with an average inflation rate of 8.4 percent for the whole year. Incidentally, in that year, inflation was expected to be 3.2 percent, according to the ECB’s December 2021 forecasts.
For much of 2022, the ECB kept repeating the ‘this-is-all-temporary’ mantra. Meanwhile, the purchasing power of our euro dwindled visibly. In the end, the bank in Frankfurt had no choice but to tighten monetary policy. However, it did so not only very late but also, when it finally began, far too weakly and slowly.
Why so weak and slow? The ECB’s December 2022 forecasts said inflation would be 2.3 percent in 2025. Squint a little, apply some mathematical massaging, and it’s almost the aforementioned target. Therefore, there’s no need to tighten policy too much and risk damaging the economy. In other words: things may not be going as they should right now, but in two years we’ll be where we want to be with inflation, and in the meantime, inflation is dropping.
In 2023, inflation came in at 5.4 percent over the year, significantly above the 2 percent target. Yet, the bank stopped raising rates at the end of 2023. Why? You can probably guess by now: because the ECB’s forecasts predicted that annual inflation in 2025 would be 2.1 percent.
The bank is now busy lowering interest rates. Why? Because inflation in 2025 will be 2.2 percent, and in 2026, it will be 1.9 percent. Says who? Says the ECB’s forecasts.
Forgive me, but given the bank’s track record, I take the reasoning behind these rate cuts with a large pinch of salt. I’m curious to see if, when the new forecasts come out in December, we’ll hear that inflation in 2027 will be sufficiently low. Who knows, maybe the ECB’s forecasting model will even suggest that inflation in 2027 could be too low. A disaster—for the ECB, that is. In that case, we might expect even more rate cuts between now and Christmas 2025.
That the inflation outlook for the coming years might not be so rosy, given deglobalisation (which drives inflation up), the energy transition (which drives inflation up), demographics (which, via ageing and increasing labour shortages, also drives inflation up), and ongoing large budget deficits in many eurozone countries (yet another inflation driver)—well, you rarely hear anyone at the ECB mention that.
As long as it doesn’t rain too much in 2025 and beyond, seems to be the bank’s main concern. Because these days, you might as well visit the ECB’s website for the latest weather forecasts rather than KNMI, given how often various ECB board members talk about climate issues. Some even more often than about inflation forecasts, which is, after all, the bank’s actual responsibility.
Edin Mujagić is an economist, fund manager of Hoofbosch Investment Fund, and author of the book Turning Point 1971. He writes a monthly ECB Watch column on the European Central Bank’s monetary policy for Investment Officer.
