Eurozone inflation slowdown fuels policy divergence: Which way for ECB rate hikes?

Introduction

In June 2024, the Eurozone economy reached an important turning point. Consumer price indices (CPI) in its three core economies—Germany, France, and Italy—all fell below market expectations, indicating a significant easing of overall inflationary pressure. Following the data release, debate within the European Central Bank (ECB) over the path of monetary policy heated up. Some Governing Council members argued that a pause in July was reasonable, while others favored deferring the decision until September. This rift over the pace of rate hikes reflects the complex challenge facing the ECB in balancing inflation control and economic recovery.

Inflation falls more than expected: signal of structural improvement

Germany, France, Italy CPI data

Latest data showed Germany's June CPI slowed to 2.5% year-on-year, below the expected 2.8%; France's CPI fell to 2.3%, below the expected 2.6%; Italy's CPI dropped to 2.1%, well below the 2.4% forecast. The simultaneous decline in the three largest economies, all below consensus, was no coincidence.

From sub-items, energy prices continued to decline year-on-year as the main drag, but more noteworthy was the modest easing of core inflation (excluding energy and food). Germany's core CPI fell from 3.0% in May to 2.8%, France from 2.6% to 2.4%, Italy from 2.2% to 2.0%. This suggests that sticky factors in Eurozone inflation are gradually fading, with services price gains moderating and the risk of a wage-price spiral diminishing.

Deep reasons for inflation easing

Multiple factors contributed to the easing. First, since starting its hiking cycle in July 2022, the ECB has cumulatively raised rates by 450 basis points, with the tightening effect increasingly visible on demand. Second, global supply chain repair, falling energy prices, and weaker demand from China and other major economies reduced external imported inflation. Third, while the Eurozone labor market remains tight, wage growth has shown marginal slowing, and reduced corporate pricing power has also dampened price transmission.

Notably, Germany's economy still risks a technical recession. As the Eurozone's largest economy, its manufacturing PMI remains below the boom-bust line, with industrial orders declining sharply. Against a backdrop of weak growth, faster inflation decline provides more room for monetary policy pivot but also adds complexity to decision-making.

Internal ECB divisions: pause vs. prudent wait-and-see

Rationale for a July pause

Some ECB governors argued that given inflation data significantly below forecasts and downside risks to the economic outlook, a July pause is fully justified. Their arguments: first, current rates are already in restrictive territory; further hikes could excessively dampen activity. Second, the disinflation trend is largely established; continuing to hike risks "overshooting"—i.e., overly tight policy damaging recovery. Third, wage growth is slowing and services inflation appears to have peaked, so no additional tightening is needed in the near term.

Considerations for deferring to September

However, a more cautious group insisted on waiting until September. Their concerns: inflation, though significantly down, is still above the 2% target, and services inflation remains sticky; premature pausing could undo anti-inflation efforts. Second, the labor market is still tight, with wage effects on prices having a lag; it is too early to signal any dovish shift. Third, geopolitical risks (e.g., Middle East tensions, energy supply uncertainty) could push up future inflation expectations, making policy flexibility crucial.

Behind the divergence: balancing data dependence and forward guidance

The internal rift essentially reflects a tension between "data dependence" and "forward guidance." Decision-makers need to adjust policy flexibly based on the latest data, while markets need clear signals to form expectations. If the ECB pauses in July but stresses further tightening is still possible, markets may become confused; if it continues to hike, it could worsen downside risks.

Notably, the pace of inflation improvement has exceeded most economists' expectations, forcing the ECB to carefully weigh "premature pivot" against "excessive tightening." Historical experience shows that in the later stages of an inflation cycle, decision-makers often let their guard down after seeing short-term improvement, leading to inflation relapse.

Market impact and policy outlook

Short-term market reaction

After the data release, Eurozone bond yields fell broadly; the 10-year German Bund yield dropped to around 2.35%, and the Italy-Germany spread narrowed. In forex, the euro weakened slightly against the dollar, reflecting a cooling of ECB rate hike expectations. In equity markets, the rate-sensitive sectors (e.g., real estate, utilities) rebounded, leading to modest gains in major European indices.

Future policy path forecast

Combining factors, the market currently expects the ECB to likely hold rates steady at its July meeting, but the statement will maintain a hawkish tone, emphasizing that a September hike remains possible. If July inflation data improves further (particularly core slowing below 2.5%), the probability of a September hike will diminish. Conversely, if Middle East tensions push up energy prices or wage data surprises to the upside, the ECB might be forced to deliver a final hike in September or October.

Even if the ECB pauses, monetary policy will remain restrictive; the balance sheet reduction will continue via "passive runoff." This means Eurozone financial conditions will not ease immediately, and credit constraints for businesses and households persist.

Medium- to long-term challenges

Over the medium to long term, structural inflationary pressures in the Eurozone cannot be ignored. Green transition, aging population, and geopolitical fragmentation could raise potential inflation. Whether the ECB's future policy framework needs adjustment—such as raising the inflation target or adopting a symmetric target—is gradually becoming a topic of academic and policy debate. For now, the focus remains on bringing inflation close to the 2% target while avoiding a hard landing.

Conclusion

The unexpectedly sharp fall in Eurozone inflation gives the ECB valuable policy space, but internal divisions also reflect the dilemma facing policymakers. Pausing too early risks reigniting inflation and damaging credibility; continuing to hike could exacerbate recession risks and cause unnecessary output losses.

From a broader perspective, the current inflation cycle is nearing its end, but the "last mile" is often the hardest. The ECB needs to balance data dependence and forward guidance while considering domestic and external conditions. For market participants, the July statement's wording, updated forecasts, and President Lagarde's press conference will be key signals for the next policy step. Whatever path the ECB chooses, transparent and flexible communication is essential to maintain market confidence and achieve price stability.