In a recent address in Dijon, France, François Villeroy de Galhau, a member of the European Central Bank (ECB) board, reignited discussions around the monetary policy of the EurozoneThis central bank official, whose expertise merges scholarly insight with practical policymaking, articulated his common yet cautiously optimistic stance, delineating a roadmap for potential adjustments in the monetary policy while simultaneously unearthing the deep-seated contradictions and challenges facing the Eurozone economy.
The latest consumer price index (CPI) data revealed that Eurozone inflation grew by 2.3% year-on-year for November, aligning closely with Villeroy’s earlier predictionsDelving into the specifics, energy prices plunged by 4.1% on a yearly basis, significantly contributing to the downtrend, while the core inflation rate (excluding food and energy) persisted at a high of 3.1%. That said, the month-over-month growth rate has moderated to just 0.1%. This structural divergence not only corroborates the time-lag effects of monetary policy transmission but also lays bare the stubbornness of service-sector inflation.
Historically, the inflation rate in the Eurozone has been in continuous descent since peaking at 5.6% in October 2023, a trend accompanying the European Central Bank's cumulative interest rate cuts totaling 225 basis points
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Villeroy particularly underscored the downward trend in housing rent inflation—decreasing from 3.8% to 2.9% year-on-year—which could continue to stymie core inflation over the next 12-18 months, thus providing a strong basis for monetary policy easingHowever, he cautioned that inflation in sticky price areas such as medical services and education, which remain elevated at 4.2%, could pose potential constraints to policy adjustments.
Following Villeroy's remarks, the futures market for interest rates saw a rise in the anticipated probability of a 25 basis points rate cut in December, moving from 75% to 82%. Conversely, expectations for an overall reduction of 100 basis points throughout 2025 were trimmed to 75 basis pointsThis seemingly contradictory market response reflects the underlying complexities in the investor sentiment towards the interplay between "policy space and economic resilience." Institutional investors' strategy shifts confirm this complexity, with BlackRock advocating for shorter-dated bonds while Morgan Stanley cautions against potential “overshooting and correction” cycles in policy expectations.
Recent public statements from within the European Central Bank illustrate a growing divergence in policy opinionsGerman central bank president Joachim Nagel maintains a "data-dependent" approach, stressing the need to observe fourth-quarter economic performance, while Spanish central bank leader Pablo Hernández de Cos calls for a quicker rate cut pace in response to the stark reality of manufacturing PMIs contracting for 14 consecutive monthsVilleroy effectively represents the centrist perspective, acknowledging the trend of declining inflation while advocating for policy flexibility to avoid market misinterpretations precipitated by overcommitment.
The Eurozone is currently grappling with the cumulative effects of a "triple shock." First, the reconfiguration of global supply chains has led to a 9.3% year-on-year decline in German machinery exports and a 12% drop in French aerospace orders, an alarming trend contributing to a hollowing out of the manufacturing sector's competitiveness
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Additionally, the high costs associated with energy transition impose a severe challenge, as the European Union’s green investment plan necessitates an annual injection of €500 billion into the economy, raising concerns about fiscal sustainabilityFinally, increasing population aging is exacerbating labor shortages, with labor force participation in Southern European countries like Italy sinking to 58.7%, thus limiting potential economic growth.
The vulnerabilities within the financial market are steadily surfacing amid shifting policy expectationsWhile the European Stoxx 600 Index has hit a historic high due to easing rate prospects, the banking stock index dipped by 4.2%, indicating market trepidation regarding a narrowing net interest marginThe data concerning cross-border capital flows is also troublingAccording to EPFR statistics, in the past four weeks, European bond funds have faced an outflow of $12.7 billion, while net short positions held by global hedge funds on Eurozone assets have risen to $34 billion.
The evolving geopolitical landscape surrounding energy supplies is reshaping economic dynamicsContinuous disruptions in Russian gas supplies have compelled Europe to expedite its energy transition process, with renewables projected to account for over 40% of energy by 2024. However, the transition’s accompanying high costs have directly pushed up industrial electricity prices, marking a year-on-year increase of 28%. A report by the International Energy Agency notes that energy costs for European manufacturing are now 45% higher than in the United States, potentially accelerating the trend of industrial migration.
In light of the diminishing space for traditional interest rate tools, the European Central Bank has begun exploring unconventional policy options
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The digital euro project has entered its second testing phase, with plans to establish initial application scenarios by 2026. This digital currency framework represents not just an innovation in payment systems but also hints at a potential recalibration of future monetary policy transmission mechanismsNonetheless, the complexities involved in technical implementation and privacy concerns may delay its actual launch.
The toolbox for macroprudential policy has further expandedThe European Systemic Risk Board has called for member states to raise their countercyclical capital buffer rate to 1.5%, while also setting a 25% loan-to-value ratio ceiling in the commercial real estate sectorThis enhanced "twin pillar" regulatory framework aims to balance overall monetary easing with structural risksYet, historical experiences demonstrate that the effectiveness of macroprudential policies during economic downturns tends to be limited.
Looking ahead to 2025, Eurozone economic policies are fraught with triple uncertaintiesFirstly, the speed of restructuring global supply chains could exceed projections, potentially leading to both manufacturing repatriation and rising costsExtreme weather events due to climate change, such as the abnormal high temperatures during the winter of 2024, may disrupt agriculture and energy systems.
Historical observations indicate that the effectiveness of monetary policy often diminishes during economic transformation periodsFrom Japan's "Abenomics" to the Federal Reserve’s quantitative easing, the law of diminishing marginal utility in policy highlights a crucial consideration