Eurozone inflation has dropped to its lowest level since June 2021, falling to 2.2% in August, down from 2.6% in July. This decline brings inflation just above the European Central Bank’s (ECB) 2% target and strengthens the case for another interest rate cut at the ECB's upcoming meeting on September 12.
The ECB, under the leadership of Christine Lagarde, is carefully weighing the decision to reduce interest rates for the second time this year. In June, the ECB made its first rate cut since 2019, lowering the main interest rate from 4% to 3.75%. As inflation continues to ease, central bankers across the eurozone are trying to strike a balance between controlling inflation and avoiding a potential recession—a strategy often referred to as achieving a "soft landing."
Global central banks are navigating similar challenges. Jerome Powell, Chair of the Federal Reserve, recently indicated that the time may be right for lowering interest rates in the United States, while Bank of England Governor Andrew Bailey has expressed caution about cutting rates too swiftly. The current trend of declining inflation follows a period of significant price increases triggered by the COVID-19 pandemic. Supply chain disruptions during pandemic lockdowns led to sharp price hikes, further exacerbated by Russia’s invasion of Ukraine, which caused global energy prices to surge. However, in August, it was a drop in energy inflation that contributed most to the decrease in the eurozone's harmonized index of consumer prices, according to Eurostat, the EU's data agency.
Core inflation, which excludes volatile components like energy and food prices, saw a slight reduction from 2.9% to 2.8%. However, inflation in the services sector edged up from 4% to 4.2%, partly driven by higher costs associated with hosting the Olympic Games in Paris, which pushed up prices in France. Bert Colijn, a senior economist for the eurozone at ING, expressed skepticism about core inflation falling below 2.5% for the remainder of the year. He noted that while the ECB is making progress towards its inflation target, the process remains slow. Colijn believes that the modest decline in inflationary pressures, combined with expectations for continued slowing of inflation next year, could be enough to persuade the ECB to cut rates in September. However, he cautioned that the ECB is still concerned about potential upside risks to the inflation outlook.
Adding to the complexity of the ECB's decision-making process is the recent drop in eurozone unemployment, which unexpectedly fell from 6.5% to 6.4%. Central banks are typically cautious about lowering interest rates in the face of declining unemployment, as it can signal tight labor markets, which might lead to renewed inflationary pressures.
Financial markets are already anticipating a rate cut, with transactions on Friday suggesting a 0.25 percentage point reduction in the ECB’s main interest rate is nearly certain. Moreover, two additional cuts are expected before the year’s end.
Sam Miley, forecasting lead at the Centre for Business and Economics Research, warned that the higher rate of core inflation and a persistently tight labor market pose risks to implementing a looser monetary policy. These factors could complicate the ECB's efforts to manage inflation without stifling economic growth. As the September 12 meeting approaches, the ECB faces the challenge of navigating these complex economic conditions to achieve its dual goals of stabilizing prices while fostering a sustainable recovery in the eurozone.