A cure for inflation

To start with the good news, headline inflation in the eurozone started to decline last November. Prices of goods and products are still rising, but at a slower pace than before. Annual inflation stood at 8.5% in January. This suggests that the peak of inflation in the eurozone was reached last October, when the annual inflation rate hit 10.6%. In the US, inflation seems to have peaked last June.

To curb inflation, the European Central Bank (ECB) and the US Federal Reserve (Fed) have raised interest rates aggressively. The fall in inflation in recent months was therefore confirmation for the ECB and the Fed that they are on the right track. It is, however, too early to declare victory over inflation, as it continues to be much higher than the level targeted by both the Fed and the ECB: an inflation rate of around 2%. High inflation is sometimes compared to a disease that the economy suffers from. Looking at the current situation, it is safe to say that inflation has become a persistent ailment. As a consequence, both central banks will continue to administer their medicine: rate hikes.

It was therefore no surprise that the Fed announced another rate hike at the beginning of February. The US central bank is expected to lift interest rates again at its March policy meeting. After that, the Fed may change course. The US economy is facing a (mild) recession this year. Falling real incomes and dwindling savings are causing US consumers to spend less money. With consumer demand declining, inflation should continue to retreat. This should give the Fed the opportunity to stop raising interest rates within a few months. Our economists expect the Fed to cut rates by the end of 2023.¹

In Europe, too, we are facing a slowdown in economic growth. But in recent months, the eurozone economy has proven surprisingly resilient. Due to the sharp fall in energy prices, energy costs are less likely to weigh on consumers’ disposable income. Europe is unlikely to escape a recession this year, but the economic contraction will be less deep than previously assumed. Eurozone GDP growth is expected to reach -0.3% in 2023, where our economists previously expected a sharper contraction (-0.9%).

But there is a catch. A recession usually leads to higher unemployment, resulting in a looser labour market and less wage pressure. With the eurozone recession likely to be less deep, the labour market will remain tighter than previously expected. This creates the risk that wage inflation – a key driver of overall inflation – will remain stubbornly high. Therefore, it cannot be ruled out that inflation will remain higher over the medium term than central banks consider desirable.²

The ECB is aware of this risk. Recently, the central bank predicted that wage growth in the eurozone over the coming quarters will be “very strong” in historical perspective.³ It is therefore not surprising that the ECB continues to insist that the fight against inflation is not yet over. In December, ECB President Christine Lagarde warned of the danger of “entrenched inflation.”⁴  By this she meant the risk that high inflation will become a structural phenomenon, as a result of which purchasing power will remain under pressure for (much) longer. This is a scenario that the ECB wants to avoid at all costs. To put it in medical terms: with a hefty dose of interest rate hikes, inflation must be prevented from developing into a chronic disease.

Early February, the ECB implemented another 0.5% rate hike. Our economists expect the central bank will continue to raise its policy rate, to a peak level of 3% that is likely to be reached in March. In fact, financial markets are considering the possibility of an even higher peak level. Only towards the end of the year will the ECB possibly start lowering interest rates. With inflation moving in the right direction, the rate-hike medicine appears to be working. But the treatment is not finished yet.

1. More about our economic forecasts and interest rate expectations can be read in the report ‘Key views on the Global outlook’ (23 January 2023) of ABN AMRO Group Economics. 

2. Read more about our economists’ view on the eurozone economy in the Global Monthly - Where is the recession?

3. Source: ‘Wage developments and their determinants since the start of the pandemic’, ECB Economic Bulletin.

4. Source: interview with Christine Lagarde, 19 December 2022.