Europe is one step closer to stagflation

Navigating Eurozone Q4 amid economic headwinds

By Ahmed Azzam | @3zzamous | 30 October 2023

ECB's dilemma_ Balancing growth and inflation
  • ECB tightens with tenth hike, hitting 4%

  • Despite hikes, ECB may pause as CPI drops to 5.2%

  • Core CPI eases to 5.3%, hinting at slower inflation

  • Economic slowdown raises market concerns; PMI signals contraction.

  • Q4 likely sees rates pause; ECB committed, no cuts until mid-next year

Monetary policy in the eurozone is showing no signs of easing and the European Central Bank recently committed its tenth consecutive interest rate hike, a move that has taken the key ECB deposit rate to an all-time high of 4%.

However, the most recent comments from ECB officials suggest the governing council may be close to signalling a pause in the current tightening cycle, as headline CPI has fallen from a high of 10.6% to 5.2%.

The major challenge going forward may now be a policy switch in favour of managing both actual inflation and inflation expectations, a task that will have been made more difficult recently by the rise in global oil prices.

Germany showed zero growth in Q2

The core CPI, the measure of inflation that excludes food and energy prices and is targeted by the ECB, has similarly moderated, from 5.7% to 5.3%. Although exhibiting a slower pace of decline than the headline CPI, this move suggests the possibility for a further moderation in headline inflation going forward.

Further weight is added to this argument by the worsening economic performance being seen across the eurozone, with Germany showing zero growth over Q2, while France and Spain managed only modest growth and Italy saw output decline.

The challenge of a soft landing

This slowdown being seen in economic growth, teetering precariously around the zero-growth threshold, is injecting an increasing sense of disquiet into the markets as the prospect of the ECB achieving a ‘soft landing’ becomes increasingly challenging from an economic perspective.

Forward looking indicators, such as the Manufacturing Purchasing Managers' Index (PMI), has now posted 15 consecutive readings pointing to a contraction in the sector, while the key services reading has now also fallen into contractionary territory.

ECB's dilemma: Balancing growth and inflation

This convergence of factors underscores the difficult dilemma confronting the ECB in the forthcoming period. The persistent escalation of interest rates may exert an overly strong downward pressure on the economy, as it seeks to rein in inflation.

Conversely, a halt in rate hikes could allow inflation to strengthen again which, coupled with the economic slowdown being seen, risks pushing the European economic landscape into a period of stagflation. The ECB may require a willingness to tolerate adverse growth figures, indicating a challenging six-month period looming ahead.

As we look toward the fourth quarter, the prospect of interest rates remaining at 4% looms large, contingent on the trajectory of inflation metrics. The ECB's commitment to maintain elevated interest rates within a static economic landscape remains strong, with any suggestions of rate cuts unlikely to be considered until the midpoint of next year.