Inflation and some other things

Inflation

Last week, my ECB Governing Council colleagues and I decided to leave interest rates unchanged so the Deposit Facility Rate – the rate through which we steer the monetary policy stance – remains at 2 per cent.¹ We concluded that incoming information was broadly in line with our previous assessment of the outlook and that inflation was on track to stabilise at our 2 per cent target in the medium term. 

The most recent staff forecasts were published in June and had headline inflation in the euro area averaging 2 per cent this year, falling to 1.6 and 2 per cent in 2026 and 2027 respectively. This was a lower near-term path for inflation than previously expected, owing to lower energy prices as well as the weakening of the US dollar.  Core inflation – that is, excluding volatile energy and food prices – was projected at 2.4, 1.9 and 1.9 per cent in 2025, 2026 and 2027 with the growth outlook remaining subdued with increases of 0.9, 1.1 and 1.3 per cent over the same period.  This was broadly unchanged from previous projections but the headline figure masks important compositional changes.

In particular, staff forecast that an expected increase in public expenditure would offset the negative effects of a (10 per cent) increase in US tariffs (more on those below), with the associated uncertainty reducing the strength of the recovery in investment and consumption. Nevertheless, consumer spending remains the main growth driver of near-term growth with wage growth – with unemployment remaining near historic lows – providing a boost to incomes.

The potential scale of an increase in euro area public expenditure has increased since the release of the forecasts in June.  In particular, NATO members have agreed on new military spending commitments that are well in excess of their previous targets. How this spending will affect the euro area economy will depend on its composition and financing.  For example, higher military spending in research and development could have a potentially large impact on growth (i.e. ‘multiplier’), crowding-in private investment and generating positive spillovers on innovation. This could also improve the growth potential of the economy.

Military spending of a different kind, however, may have favourable demand effects only in the short term, with muted long-run effects. In addition, unfunded deficit and debt increases, especially in countries whose fiscal positions are already vulnerable, may have detrimental effects overall, possibly resulting also in higher inflation.    

Risks surrounding the forecast

The staff forecast is contingent upon a sustained strengthening of the euro vis-à-vis the US dollar, as well as a fall in energy prices. However, these are historically volatile components and therefore are usually quite susceptible to revisions in subsequent forecast rounds.  I will keep a close eye on developments in these markets to ascertain whether the likelihood of the central forecast materialising has changed.

Core inflation is far more stable. While it is now close to target, the labour market is an important barometer of whether it will remain there on a sustainable basis. Although staff project that the unemployment rate will remain low, the changing nature of working arrangements means that this will not necessarily translate into an increase in wage pressures.  Evidence suggests that the majority of wage growth now comes from job transitions (i.e., moving from one job to another).  A slowdown in posted vacancies that increases the difficulty in switching jobs – due to an economic slowdown from trade frictions for instance – implies weaker wage pressures and lower core inflation. Alternatively, an increase in vacancies, tied to greater defence spending for example, could place upward pressure on wages and core inflation.

With unchanged growth projections resting on an expected fiscal expansion, the coming months will see greater clarity on the composition of these packages. For example, a spending programme concentrated on imports will have less of an effect on growth (and inflation, if the euro remains strong). It is also important to understand the capacity to finance these programmes, i.e., whether entirely by debt or partially through tax increases and/or reprioritising spending choices. There are still many unknowns, with different approaches likely to have different implications for inflation and therefore the necessary monetary policy response.

US trade and fiscal policy

Inevitably, I need to mention US trade and fiscal policy. 

There is insufficient detail to provide any considered analysis of Sunday’s news of a 15 per cent tariff “deal” (other than to say that headlines such as “EU agrees to pay 15% tariff on most exports to US” show a misunderstanding of tariffs).  These tariffs will require a mix of absorption by firms (reducing their profits) or, as analysis of previous tariff increases shows, increasing the cost of these goods for US consumers.  Overall, compared to 6 months ago, US tariffs of 15 per cent on EU goods will dampen economic growth, although it will be partially offset by reducing uncertainty and the likelihood of more damaging trade war that has dominated the economic environment since the start of the year. However, in view of the unpredictability that has been such an obvious feature of US Administration policy over the last six months, and the fact that details matter (especially on trade issues), I will refrain from commenting further for the time being.

As for US fiscal policy, it does look as if there will be a large increase in US Treasury debt issuance which could affect pricing for a wide range of assets across the globe.  Again, something to keep a close eye on.

Ireland

Let me address the inflation picture here in Ireland. The Irish economy and public finances have entered this period of heightened uncertainty from a strong position but there are also underlying vulnerabilities that need to be managed carefully. Monetary and fiscal policy are of course important levers for overall macroeconomic stabilisation. Inflation continues to stabilise in Ireland with the most recent CSO HICP estimate showing inflation at 1.6 per cent, down from a rate of 4.9 per cent a little over 18 months ago, and below the rate in other European states. While headline inflation has eased substantially (influenced by a decline in externally driven prices), inflationary pressures remain high in some areas. Our most recent forecast is for a continued easing of headline HICP, driven primarily from a downward revision in commodity price assumptions.

Fiscal policy plays an important role in supporting monetary policy as it impacts Ireland. Overall, the current global economic environment presents important trade-offs for fiscal policy and I note the publication of both the Summer Economic Statement (PDF 1.19MB) and the National Development Plan this week. As I have said previously, fiscal policy has to strike a balance between delivering on the necessary rise in public capital investment in the coming years (not least to manage some of the infrastructure challenges that the country faces), and current spending demands that seek to maintain or enhance existing levels of public services.

Conclusion

To sum up, inflation in the Euro area has stabilised while growth is developing broadly in line with expectations.  The Governing Council is determined to ensure that inflation stabilises at our 2 per cent medium-term target and, in the circumstances, last week’s decision to keep the DFR at 2 per cent was relatively straightforward.  For my part, I think we have reached a point in our easing cycle where we can wait and see whether the data and evidence indicates the need for a change in our monetary policy stance.  We are not committing to a particular rate path, and will continue to take account of new information when it arrives (our next monetary policy meeting is in September, when we will have an updated set of forecasts and associated set of risks surrounding the projections).  But we also recognise that we have to remain humble in the face of a rapidly evolving geopolitical and geoeconomic environment. 

[1] For tracker mortgages in Ireland linked to the ECB’s Main Refinancing Rate (MRO), the MRO is 2.15 per cent.

Gabriel Makhlouf