Eurozone Inflation at 3% Stagnation: Crossroads of Policy Choices and Market Expectations Game

Keywords

Eurozone inflation; second-round effects; ECB interest rate policy; September rate hike expectations; monetary policy flexibility

Introduction: Policy Resilience in the Fog of Inflation

Since the ECB launched its rate hike cycle in 2022, the Eurozone inflation rate has fallen significantly from its peak of 10.6%, but in 2024, the decline has clearly slowed, currently hovering around 3%. While this level represents a substantial drop from historical highs, it remains far above the ECB's 2% medium-term target. Recently, ECB officials have signaled in multiple forums that "no second-round inflation effects have been observed" while emphasizing maintaining policy flexibility, immediately triggering intense market debate on whether to raise rates further in September.

The stickiness of inflation and the size of policy space constitute the core tension in the current Eurozone economy. On one hand, the fading of energy price shocks, supply chain recovery, and cooling demand are pushing inflation down; on the other hand, persistently high services inflation, accelerating wage growth, and geopolitical uncertainties make the central bank reluctant to declare victory. In this "last mile" of inflation control, the ECB is facing the severe test of precise adjustment: excessive tightening could strangle the fragile recovery, while premature easing could waste previous efforts.

One, The "Stubborn Illness" of Inflation: Structural Contradictions Behind 3%

The current Eurozone inflation rate of around 3% is essentially the result of multiple forces intertwined. Looking at sub-item data, energy prices have turned negative year-on-year, becoming the main drag on overall inflation; food inflation has also fallen from double digits to below 5%. However, core inflation (excluding energy and food) remains stubbornly above 4%, with services inflation particularly high, hovering around 4.5%. This means that Eurozone inflation has shifted from "supply-driven" to a mixed model of "demand-driven" and "cost-push".

The second-round effect, the risk of a wage-price spiral, is the variable the ECB is most vigilant about. The so-called second-round effect refers to workers demanding higher wages to maintain purchasing power during high inflation, which businesses pass on to consumers, forming a self-reinforcing inflation cycle. Although core inflation remains high, ECB officials' assessment indicates that this vicious cycle has not yet substantially formed. The reasons are: first, although Eurozone wage growth is accelerating, it is mainly concentrated in compensatory negotiations to hedge against past purchasing power losses, with anticipatory wage increases not yet widespread; second, corporate profit margins expanded significantly during high inflation and still have room to absorb costs without passing them all on; third, if economic growth continues to slow, the labor market may loosen, weakening wage growth pressures.

However, "not observed" does not mean "will not appear." The ECB's internal monitoring of wage dynamics is refined to industry and country levels. The results of wage negotiations in large economies such as Germany and the Netherlands, as well as wage trends in labor-intensive industries such as services and construction, are key tracking objects. Once these indicators accelerate, the second-round effect could evolve from a "potential risk" to a "real threat."

Two, Policy Dilemma: The Balancing Act Between Maintaining Tightening and Retaining Flexibility

Facing 3% inflation, the ECB's current policy remains in a restrictive zone. Since July 2022, the ECB has raised rates by a cumulative 450 basis points, with the main refinancing rate reaching 4.25% and the deposit facility rate at 3.75%. Such a deep tightening cycle is unprecedented in Eurozone history. The key question is whether this interest rate level is sufficient to pull inflation back to target?

Based on historical experience, ECB President Lagarde has repeatedly cited the metaphor that "the last mile is the most difficult." When inflation falls from double digits to 3%, the remaining part is often driven by domestic components such as wages and service prices, which are less sensitive to interest rates than energy and commodity prices. Therefore, even though the real interest rate is already positive, the central bank needs to maintain a "restrictive stance for a sufficiently long time" to ensure inflation expectations remain anchored. This is why the ECB repeatedly emphasizes "not预设路径" - not ruling out any possibilities, including further rate hikes if necessary.

But at the same time, the European economy is facing severe growth pressures. The Eurozone manufacturing PMI has been in contraction territory for a long time, with Germany's core country PMI falling to 43.1 in July, the lowest since the financial crisis (excluding the pandemic period). Although services remain in expansion territory, momentum has clearly weakened. Further rate hikes could push the economy into a deeper recession, even triggering financial stability risks, such as a renewed surge in government bond yields for highly indebted member states (Italy, Greece, etc.).

This dilemma between "fighting inflation" and "stabilizing growth" forces the ECB to adopt a "hawkish but dovish" tone in policy communication. On one hand, officials repeatedly emphasize that "inflation is too high," suggesting the door to rate hikes is not closed; on the other hand, they clearly state that "policy will depend on data," leaving room for pauses or shifts. This flexibility itself is the most rational choice in the current uncertain environment.

Three, The September Rate Hike Suspense: Market Expectations vs. Central Bank Reality

Currently, market expectations for a September rate hike probability remain between 30% and 40%, far lower than the certainty of the 2023 rate hike cycle. This divergence reflects the difficulty of judgment. Arguments for rate hikes include: services inflation remains sticky, and if wage negotiation results exceed expectations, it will push up costs; Eurozone core inflation still exceeds 3%, far from target; if no rate hike this time, it might be interpreted as a policy shift signal,反而 stimulating demand and inflation. Arguments against rate hikes include: economic downside risks are intensifying, high interest rates are suppressing credit and investment; inflation expectations have stabilized in the short term, further rate hikes are not worth the cost; the September meeting will release new economic forecasts, and if growth forecasts are significantly lowered, observation should be paused.

Notably, ECB officials' statements are not uniform. Hawks like Dutch Central Bank President Knot still advocate that "inflation has not yet been defeated," while doves like Italian Central Bank President Panetta emphasize that "the economy has slowed enough." This internal divergence precisely shows that the September meeting will be a "difficult decision" highly dependent on data. Key variables include: whether August's inflation data will unexpectedly rebound (especially core and service sub-items); whether Q2 wage growth indicators accelerate; and the coordinated signals from the US and European central banks at the August Jackson Hole global central bankers' meeting.

From a broader perspective, the ECB's September choice will also be deeply influenced by the Fed's policy path. If the Fed cuts rates in September, the interest rate differential between the euro and dollar will narrow, and the euro may strengthen, which helps curb import inflation and gives the ECB some breathing room; conversely, if the Fed maintains high rates, the ECB will find it harder to choose easing, otherwise facing capital outflow and currency depreciation pressures.

Four, Forward Outlook: Unclear Path, Increasing Differentiation

Looking ahead to the second half of the year, Eurozone inflation will likely fluctuate between 2.8% and 3.2%, struggling to quickly fall back to the 2% target. This means the ECB may enter a "high-rate plateau period" - whether rates rise in September or not, they will remain high in the foreseeable future. Even if rates rise in September, it will likely be the last of this cycle; even if no hike, the rate cut timing won't come until at least early 2025.

This "high-level standby" policy state will exacerbate financial differentiation within the Eurozone. Countries with stronger fiscal positions like Germany and the Netherlands can better withstand the suppression of high interest rates on corporate investment and household consumption; while heavily indebted countries like Italy and Spain face the risk of financial market repricing. Although the ECB retains the "Transmission Protection Instrument" (TPI) to disorderly spread widening, the triggering conditions for this tool are extremely strict and cannot serve as a normalized stabilization measure.

For market participants, the most important thing in the current stage is to abandon the linear thinking of "rate hike peak means easing." The ECB is shifting from a "certain rate cut cycle" to an "uncertain plateau period." Asset prices will rely more on the multi-dimensional game of growth data, inflation expectations, and geopolitical shocks. In this environment, maintaining sensitivity to policy details and flexible response to data changes is more important than betting on a single direction.

Conclusion: Finding Anchors in the "Last Mile"

The Eurozone inflation hovering at the 3% threshold is both the result of 18 months of aggressive rate hikes and a new test facing policy shifts. The ECB officials' judgment that "no second-round effects have been observed" provides a reason to pause rate hikes; while the commitment to "maintain policy flexibility" retains space for应对意外. Whether to raise rates further in September is more a matter of timing and rhythm than a directional choice.

Looking at the big picture, the Eurozone is undergoing an unprecedented "inflation governance experiment": it must digest the lagging effects of external supply shocks, prevent potential risks of internal wage-price spirals, while simultaneously achieving economic soft landing and financial stability. In this process, every central bank statement, every set of data, and every meeting will become an amplifier of market sentiment. For investors and policymakers, perhaps the most rational attitude is not to guess the timing of the next rate hike, but to accept a new macro environment that is complex, differentiated, and full of uncertainties, and rebuild the decision-making framework accordingly.

The "last mile" of inflation has never been smooth, but it is precisely in this rugged terrain that true policy wisdom and market resilience can be tempered. The ECB's path will remain one of the most important variables in the global macro economy in 2024.