Has the fight against inflation been won?

The hot August is now just a memory. This also applies to many members of the ECB Council, who met on Thursday in autumnal Frankfurt for their regular meeting. With their decision, however, they are building on the interest rate turnaround initiated in early summer: for the second time, the Council is lowering the current key interest rate, the deposit rate, by 0.25 percentage points to 3.5 percent.

In June, the ECB initiated the interest rate turnaround with a similar step. A month later, in July, the central bankers waited and left interest rates unchanged.

Core inflation stagnates near 3 percent

The second interest rate cut this year was made possible because both the monetary policy and the economic environment have changed in the past two months. According to a preliminary calculation by the European statistics office Eurostat, inflation in the euro zone fell from 2.6 to 2.2 percent in August. This means that the at times extremely high inflation is approaching the target value of the ECB, which is aiming for an inflation rate of 2 percent in the medium term.

However, the decline in inflation was due to the fact that energy prices fell significantly compared to the previous year. On the other hand, the price increase in the services sector, at 4.2 percent, remains a cause for concern, as this was actually an increase compared to the previous month and represents the highest value this year. The price increase for food, alcohol and tobacco was 2.4 percent, which was also a slight increase compared to the previous month.

In addition, core inflation has been stagnating at around 3 percent for months. Central bankers pay particular attention to this as an indicator of the inflation trend because it excludes the volatile prices of energy and food. On the other hand, there were positive signals from wage developments, which weakened in the second quarter while still remaining at a high level. Wages and salaries are an important driver of inflation.

From the perspective of many economists, it is still too early to declare victory in the fight against inflation. Towards the end of the year, overall inflation could even move back towards 3 percent due to a statistical base effect related to the price of oil. But that is not yet certain, as the price of the European Brent variety has surprisingly fallen significantly in the past two weeks and is now no longer above, but below, the level seen at the end of 2023.

At the same time, the economic environment in the euro zone has deteriorated in recent months. Although gross domestic product increased by 0.3 and 0.2 percent in the first two quarters, economists are expecting real gross domestic product (GDP) to grow by an average of just 0.7 percent for the year as a whole.

Germany, the largest member state, has also been in stagflation for over two years – a mixture of economic stagnation and high inflation. However, since inflation in Germany has recently fallen to 1.9 percent according to the German calculation method and to 2 percent according to the European method, stagflation has developed into pure stagnation.

However, there is currently no end in sight to the economic weakness, especially in German industry. Some economists even expect a further deterioration, which could also have a negative impact on developments in the entire euro zone.

The financial markets had been firmly expecting the second interest rate cut, which is why the discussion there has long been about medium-term interest rate developments. Most economists expect an interest rate hike of 0.25 percentage points in December, although some do not rule out a reduction in October due to the economic slowdown.

They see the target level in the current interest rate reduction cycle as being between 2 and 2.5 percent towards the middle or end of 2025. This is also roughly where the neutral interest rate is located, at which monetary policy is neither expansionary nor restrictive. However, this interest rate cannot be measured, only estimated, which is why the assumed level repeatedly causes discussions among economists.

Adaptation of the operational framework

On Thursday, the ECB not only adjusted the monetary environment with the interest rate cut of 0.25 percentage points, but also made an adjustment to its operational framework announced in mid-March. At that time, the central bank announced that it would reduce the gap between the deposit rate* and the main refinancing rate* from 0.5 to 0.15 percentage points in September. Accordingly, it reduced the latter by 0.6 percentage points to 3.65 percent as of September 18. The interest rate for the marginal lending facility* also fell by 0.6 percentage points to 3.9 percent. However, the changes in the gap to the deposit rate are not a monetary policy measure and therefore have no impact on the monetary environment.

Due to the enormous excess liquidity in the market, currently around 3 trillion euros, which the ECB itself has created through securities purchases, among other things, the main refinancing rate has hardly been relevant for banks for years. The ECB therefore controls monetary policy via the deposit rate and no longer via the main refinancing rate as it used to. The deposit rate has thus become the actual key interest rate, which also plays an important role in the interest that banks pass on to savers.

However, the central bank is now slowly reducing excess liquidity and wants to support a normalization of monetary policy by reducing the spreads between interest rates.

* The ECB has three key interest rates: the deposit rate, the main refinancing rate and the marginal lending rate. The deposit rate determines the interest that banks receive when they deposit money with the central bank until the next business day. The main refinancing rate, on the other hand, determines the price at which banks can obtain liquidity from the central bank for a week. If they only need liquidity overnight until the next business day, they can use the marginal lending rate, but this has a higher interest rate.

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