By Balazs Koranyi

Euro Zone Inflation Trends

TALLINN (Reuters) – Euro zone inflation is falling as predicted, reducing the risk that further rate cuts could disrupt disinflation. However, the European Central Bank (ECB) must exercise increasing caution as rates decrease, according to ECB board member Isabel Schnabel.

Expected Rate Cuts

The ECB is widely anticipated to lower interest rates again next month due to easing price pressures. Schnabel’s remarks are likely to strengthen these expectations since the bank’s “baseline” already forecasted two additional rate cuts this year following June’s initial cut.

“Recent data remain consistent with the baseline scenario that foresees that inflation will sustainably fall back to our 2% target by the end of 2025,” Schnabel stated in a lecture in Tallinn, Estonia.

Cautious Approach to Policy Easing

While Schnabel did not directly call for policy easing, she mentioned that gradual rate cuts might not undermine the disinflation process, contrary to concerns from some policymakers.

“Along with signs of a potential decline in economic momentum in other parts of the world, there is less risk that further moderate and gradual dialing back of policy restraint could derail the path back to price stability,” she added.

Perspectives from Other Central Bank Leaders

Finnish central bank chief Olli Rehn noted that weaker economic growth strengthens the case for a September rate cut, while Latvia’s Martins Kazaks agreed that the baseline scenario is on track.

Need for Caution

Schnabel, who played a crucial role in the ECB’s most significant series of interest rate hikes in 2022-23, emphasized that caution is required as rates lower because the exact relationship between monetary restriction and stimulus remains uncertain.

“The closer policy rates get to the upper band of estimates of the neutral rate of interest – that is, the less certain we are about how restrictive our policy is, the more cautious we should be,” Schnabel explained.

She suggested that adjusting rates quarterly might be more suitable, emphasizing the necessity of thorough reviews of assumptions under the baseline scenario for timely policy adjustments.

Economic Outlook

Schnabel downplayed the risk of an economic downturn, asserting that a “soft landing” remains more likely than a recession.

Part of Schnabel’s caution arises from concerns that inflation may rebound if the economy shifts unexpectedly. “Although surveys suggest weaker wage growth ahead, the staggered nature of wage negotiations implies that workers may take longer than projected to recoup their purchasing power,” she remarked.

Strong wage growth may persist due to a tight labor market and an imbalance between labor supply and demand, challenging the ECB’s view of wage growth as merely a reaction to inflation’s impact on purchasing power.

Moreover, the long-anticipated rise in productivity seems delayed, and poor productivity growth—potentially worsened by trade tensions—could further pressure wages, Schnabel indicated.