European stocks and bonds have faced numerous challenges over recent years, including war, an energy crisis, and surging inflation. However, there are signs of a positive turnaround. For instance, Germany’s DAX index of shares has seen a 14% increase since November. Yields on French ten-year government bonds have also dropped, while even Italian yields have fallen. This surge in investor optimism is partly due to inflation falling more rapidly than anticipated, but it also reflects the underlying weakness in the economy, potentially leading to upcoming interest-rate cuts.
Will policymakers take action? November saw inflation at 2.4%, close to the European Central Bank’s 2% target. The Federal Reserve in the United States has issued dovish signals, and markets are pricing in multiple ECB cuts. However, there is unease regarding policymakers being slow to react as Europe’s economy weakens rapidly.
Two main concerns stand out. The first is wage growth—a factor that is a significant source of inflation. However, there are early indications of slowing wage increases, easing this concern. Secondly, the overall economy’s health is under duress due to weak international demand, high energy prices, and a fading consumption boom in parts of Europe. Lower market interest rates may have the potential to alleviate these challenges, but they mainly reflect falling inflation and are unlikely to stimulate demand significantly.
Another reason for central bankers to act swiftly is that interest-rate changes take time to impact the economy. It takes at least a year for higher rates to alter investment and spending decisions, influencing a lower demand. The flip side is that rate cuts in the next few months will not impact the economy until late 2024, meaning a need for the central bank to be proactive now to avoid having to cut aggressively at a later stage.
Lastly, market volatility could emerge in January’s inflation data, demanding the ECB to be even more cautious. The central bank’s risk of being too slow on the way down exists because wage data is published with a delay, and officials are often reluctant to rely on real-time indicators.
With the upcoming months holding potential volatile inflation data, the need for prudent decision-making by the policymakers is evident. The risk of being too slow or too aggressive in addressing the economic challenges calls for the ECB to be proactive and responsive.
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Overall, it’s important for the European Central Bank to be proactive and responsive, given the economic challenges. With the upcoming months holding potential volatile inflation data, and the risk of being too slow or too aggressive in addressing the economic challenges, it calls for the ECB to be proactive and responsive.
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