The Matchstick of Inflation
Both in the U.S. and Europe, the excess liquidity created over past decades has been only partially reabsorbed. It remains ready to fuel inflation if a matchstick is struck
Matchsticks can take the form of demand or supply shocks. Demand shocks are less likely in Europe, where economic conditions are weakening, growth is contained, and public deficits are under control—conditions not mirrored in the U.S., where such shocks remain a concern.
During 2024, inflation in both the U.S. and the eurozone stabilized its decline below 4% and toward 2%. Coming from the alarming levels of 2022—close to or exceeding 10%—this decline fostered the notion that the post-pandemic inflationary episode had been successfully resolved. This optimism encouraged a reduction in interest rates, which many now hope will continue, albeit with no clear endpoint in sight.
However, the average inflation rate in the second half of 2024 was 2.7% in the U.S. and 2.2% in the eurozone. Moreover, inflation rose month-on-month during the last three months of the year, reaching 2.9% in the U.S. and 2.4% in the eurozone by year-end.
The average of the last three seasonally adjusted monthly inflation rates stood at 0.3% in the U.S. and 0.21% in the eurozone, corresponding to annualized inflation rates of 3.7% and 2.6%, respectively. If the goal is a stable 2% inflation rate, we are not there yet.
The latest U.S. inflation figures have reignited expectations of lower interest rates and driven further stock market rallies. However, these expectations are weakly justified, as they depend on a slowdown in price growth excluding food and energy as well as on the fact that the overall index increase was less than anticipated.
The situation differs between the U.S. and the eurozone. In the latter, inflation is lower, the growth rate of the real economy is lower and decreasing, fiscal policies are expected to be less expansionary, and the potential inflationary impact of Trump's threatened tariffs is smaller. Therefore, the rapid conclusion of the inflation rollback is more uncertain in the U.S.
Will Interest Rates Fall?
Will central banks endorse the end of the inflation threat by further reducing interest rates?
In the U.S., the higher inflation rate, robust economic conditions, and prospects of expansionary fiscal policies suggest caution in completing rate cuts. IMF’s projections of US 2025 real growth are now 2,7%, 0,5% higher than the forecast released two months ago. Interest rates remain high, between 4.25% and 4.50%, or about 1% in real terms (net of inflation). The Federal Reserve can only resume lowering rates if inflation data indicate a renewed decline.
In the eurozone, the likelihood of further rate cuts should be higher given the lower inflation rate and a weakening economy, with some fears of recession. IMF’s forecasts 1% real growth for the eurozone, 0,2% down from projections released in October 2024. However, European rates are already more than a percentage point below U.S. rates, and, in real terms, stand at about 0.5%. Should inflation stabilize at 2%, the current rate would yield a real rate of 1%. Moreover, the euro has been weakening in terms of dollars.
The ECB, like the Federal Reserve, has yet to clarify what monetary rate it deems compatible with the 2% inflation target. However, assuming that the real rate should remain positive, between 0.5% and 1%, is reasonable. This means we are close to the normal rate for normal times, leaving little room for further reductions. If any room exists, it should be used cautiously and only if inflation shows clear signs of declining further.
Prudence is also necessary to preserve room for significant rate cuts if a severe economic downturn threatens liquidity and the solvency of financial intermediaries. The zero or negative rates prevalent for several years in the past left a legacy of inflationary excesses that now discourage a return to such levels. Therefore, we are also not far from the rate level that provides a margin of about two percentage points for emergency monetary support. Stimulating economic growth further through monetary policy is not advisable at this stage.
What could threaten a return to excessive inflation in the short and long term? The "fire" of inflation requires fuel and a matchstick. The fuel is liquidity, which, when abundant, allows for purchases at rising prices.
In both the U.S. and Europe, the excess liquidity created over past decades has only been partially reabsorbed and remains ready to fuel inflation if a matchstick is struck. To reduce it more swiftly, central banks would need to accelerate the sale of assets acquired through Quantitative Easing or otherwise neutralize the liquidity created by those purchases. However, this would jeopardize the financing of public deficits.
Matchsticks can take the form of demand or supply shocks. Demand shocks are less likely in Europe, where economic conditions are weakening, growth is contained, and public deficits are under control—conditions not mirrored in the U.S., where such shocks remain a concern.
Nevertheless, supply shocks cannot be ruled out in either the U.S. or Europe. Geopolitical tensions could suddenly drive up the prices of raw materials and energy, while wars, tariffs, and protectionism could disrupt the normal flow of production and trade. The increasing monopolistic tendencies of many markets could also exacerbate rising prices.
Inflation can also ignite without a matchstick if inflationary expectations emerge and become self-fulfilling, particularly if monetary policies lose their anti-inflationary credibility. This credibility, lost since the early 2000s, has been partially restored by combating post-pandemic inflation. Let us hope policymakers continue to act in ways that preserve and strengthen it.
Franco Bruni
Franco Bruni is an Emeritus Professor, at Bocconi University, he is also President of the Institute for International Political Studies (ISPI). Franco is a member of the Board of Directors, Banca Sella Holding and a research fellow at IEP@BU
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