After the European Central Bank (ECB) cut interest rates again in December, ECB President Christine Lagarde recently stated in a podcast that the ECB is approaching its final inflation target. She said: "We're getting very close to that stage when we can declare that we have sustainably brought inflation to our medium-term 2%”. Lagarde's statement suggests that the once "stubborn" inflation issue has largely been brought under control. This is good news for the Eurozone economy, which has been plagued by inflation in recent years.

The ECB recently released a report lowering its inflation forecasts. It now expects the CPI growth rate for 2024 to be 2.4%, down from the previous forecast of 2.5%. For 2025, it expects the CPI growth rate to be 2.1%, down from 2.2%. As for 2026, the CPI growth rate is expected to be 1.9%, unchanged from the previous estimate. This aligns with market expectations. According to Bloomberg, economists generally expect the inflation rate to reach 2% in the second quarter of 2025 and fall to 1.9% a year later. Core inflation is expected to decrease more quickly than in the previous survey, reaching 2% by the third quarter of 2025. However, as inflation eases, the Eurozone economy is also becoming increasingly sluggish. This synchronized decline, as previously foreseen by ANBOUND, indicates that inflation's stickiness is a long-term issue, and the high-interest rate policy that constrains inflation will inevitably hurt the European economy itself. Notably, Lagarde acknowledged in her remarks that inflation in the services sector remains high. She pointed out that the price increases in services are still nearly double the ECB's target and urged policymakers to closely monitor wage and corporate profit trends across the 20 Eurozone countries. This means that inflation will continue to influence the ECB's decisions and the direction of the Eurozone economy for the long term.

Similarly, while the ECB lowered its inflation forecast, it also downgraded its economic growth outlook. It now expects the GDP growth rate for 2024 to be 0.7%, down from the previous forecast of 0.8%; for 2025, it expects GDP growth to be 1.1%, down from 1.3%; and for 2026, the GDP growth rate is expected to be 1.4%, down from 1.5%. Notably, these expectations are based on the assumption that the central bank will continue its interest rate cuts, which means the ECB's monetary policy will not change the trend of economic slowdown in the medium term. Meanwhile, unlike the Federal Reserve's hawkish rate cuts, the ECB's upcoming rate cuts will be much clearer as the economy continues to slow. So far this year, the ECB has cut rates four times. According to Lagarde's remarks, the market expects the ECB to cut rates four more times next year, with the deposit facility rate potentially falling from the current 3% to 2% by mid-2025.

When the Russia-Ukraine conflict broke out, ANBOUND discussed the fragmentation trend caused by the breakdown of Europe's geopolitical relations. Currently, this fragmentation is becoming more evident as the European economy continues to struggle. On the one hand, the driving forces behind the Eurozone's economic growth have already shifted. Due to energy issues and geopolitical instability caused by the Russia-Ukraine conflict, European manufacturing has been significantly impacted, and the economic growth drivers have further shifted toward the services sector. Data shows that the preliminary manufacturing PMI for the Eurozone in November was 45.2, below the expected 46 and the previous value of 46. the preliminary services PMI in November was 49.2, below the expected 51.6 and the previous value of 51.6. Meanwhile, the preliminary composite PMI for November was 48.1, below the expected 50 and the previous value of 50, marking the lowest level in 10 months and falling below the 50 threshold that separates growth from contraction. The latest data shows that the preliminary manufacturing PMI for December was 45.2, slightly below the expected 45.3, while the preliminary services PMI for December was 51.4, above the expected 49.5. This indicates some improvement in the services sector, with its contribution to the economy increasing, while the contraction in manufacturing is becoming more severe. On the other hand, regional divergence in the Eurozone economy is also becoming more pronounced. Countries like Spain, Ireland, and Greece, which have benefited from the rebound in tourism, are performing relatively well, while Europe's largest economies, Germany and France, are facing difficulties due to factors like "deindustrialization". Germany, once the economic powerhouse of Europe, may even continue to shrink this year. Deutsche Bundesbank forecasts that the country's GDP will shrink by 0.2% this year, marking the second consecutive year of recession after a 0.3% decline in 2023. The central bank stated that the decline in German manufacturing is accelerating, and the small recovery in services is insufficient to compensate, with Germany still in a recession. Worse yet, the Bundesbank predicts that the German economy may face years of stagnation or even further recession.

At the same time, years of high interest rates have affected household income, leading to political instability in several countries within the Eurozone. France is mired in a political deadlock, with its 2025 budget being delayed due to a change in government, causing bond yields to spike and financial markets to become turbulent. In Germany, the coalition government is also diverging, facing a reorganization of the political landscape. With Donald Trump soon reassuming the U.S. presidency and pushing for deeper de-globalization, not only is Europe's foreign trade facing new obstacles and risks, but the political turmoil within Europe will also intensify, further undermining the stability and growth of the European economy. Recently, following the ECB's decision to cut interest rates, the euro has depreciated further. So far this year, the euro has fallen more than 5% against the dollar, creating a stark contrast with the strength of the U.S. dollar.

Despite the bleak economic outlook, the issue of services sector inflation means that the ECB's monetary policy easing path still faces concerns and it will be difficult to implement large or rapid rate cuts to stimulate the sluggish economy. Moreover, the ECB is unlikely to return to the negative interest rate era. Gabriel Makhlouf, Governor of the Central Bank of Ireland, stated that he still favors gradual rate cuts rather than “over large moves”. When discussing the so-called neutral interest rate, Makhlouf warned that “people who are saying that (the neutral rate is) below 2 are probably ahead of themselves”. The neutral interest rate is an unobservable level where monetary policy neither restricts nor stimulates economic output. Lagarde also emphasized that the ECB is focused on achieving 2% inflation and is setting monetary policy with that goal in mind. She strongly hopes to reach this target, rather than returning to the negative interest rate environment, as such a policy could lead to irreversible change in market participants' psychology. The ECB’s dilemma further suggests that the Eurozone economy is unlikely to free itself from the fragmented and stagnant outlook.

Final analysis conclusion:

The ECB believes that inflation is largely under control and has outlined a path for interest rate cuts in the face of a progressively weaker economy. However, the shadow of inflation makes it difficult for the central bank to return to the previous era of negative interest rates. Similarly, under both internal and external pressures, as well as changes in economic structure, monetary policy stimulus is unlikely to alter the fragmentation trend of the Eurozone economy or pull Europe out of its economic slump.

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Wei Hongxu is a Senior Economist of China Macro-Economy Research Center at ANBOUND, an independent think tank.