Europeans hoping to never have to see inflation again could be in for a long, cold winter. According to Eurostat, the euro zone’s annual consumer price inflation for November was 2.3%, which is an uptick from 2.0% in October and 1.7% in September. This means that inflation seems to be returning to the levels from the first half of this year when the average rate exceeded 2.5%.
Belgian inflation was back at 5% in November, after having dropped into the 4.3-4.5% range earlier in the fall. In Croatia, inflation has bounced back up to 4%, where it has not been since May. Estonia, the Netherlands, and Slovakia also have inflation rates above 3.5% for November.
Although Eurostat has not yet published numbers from seven of the 27 EU member states, it is painfully clear that inflation is still lurking in the European economy. I was hoping that the European Central Bank at its December meeting would put an end to the interest rate cuts for now. If there ever was a time for tight monetary policy, it is now.
Unfortunately, they did not. Citing concerns about sluggish GDP growth, the ECB’s Governing Council continued the bank’s streak from earlier this year and executed another 0.25 percentage-point cut.
For most of 2024, the ECB has been more determined to lower interest rates than the Federal Reserve has. This is a break with tradition: over the past 15 years, these two central banks have closely coordinated their monetary policy. There is a fair chance that the Federal Reserve will band together with the ECB again and cut interest rates in the U.S. next week.
The Fed has often led with an adjustment in its federal funds rate, with the ECB following suit. Earlier this year, that changed when the ECB took the initiative and led the rate cut rally; like a Johnny-come-lately, the Fed waited until September with its first cut. When it came, on the other hand, it was in the form of a big 0.5 percentage-point cut. It was then followed by a quarter-point cut in early November.
I have disagreed with the majority of Fed analysts over the last couple of years and, accordingly, been accurate in my predictions of the Fed’s policy moves. After the Fed’s September and November cuts, I agreed with the general outlook among analysts that another rate cut was coming. That does not mean I condoned it. On the contrary, I have criticized the recent rate cuts, in no small part due to the persistence of inflation in the U.S. economy.
My criticism has turned out to be well-founded. Despite the Fed’s monetary tightening in 2022 and 2023, inflation has not fallen back to the 2% neighborhood where the Federal Reserve would like it to be. Therefore, it was irresponsible of the Fed to make the September and November rate cuts.
Put simply: without a deeper understanding of why inflation does not fall back to 2%, it is downright foolish to make more rate cuts.
Hopefully, the Federal Reserve is taking seriously the rebound in the inflation trend reported in Figure 1 below (blue line). A largely similar euro zone trend thrown in for reference (gray line):
Figure 1
There are several risks associated with more rate cuts. One of them is a flip back to negative interest rates. Suppose that the Fed makes another 0.25 percentage point cut next week so that the federal funds rate drops to 4.33%. Suppose also that inflation rises along its current trend, reaching 3% in January and 3.5% somewhere in March. This reduces the positive net interest rate to less than 1% and by then, the expectations in the financial markets would be of a negative net interest rate, i.e., a situation where inflation is higher than the interest rate.
Negative interest rates are bad for the long-term stability of both the financial system and the economy as a whole. They make it relatively cheaper to go into debt and relatively more expensive to make productive investments. Long story short, a negative interest rate promotes all sorts of short-sighted speculative activity over long-term capital formation.
To be fair, it would take a fair amount of bad luck, so to speak, for the U.S. economy to end up back with inflation at 3.5-4% again. However, that amount of bad luck is reduced by the Federal Reserve every time it cuts interest rates: for every cut, the Fed increases the money supply; for every infusion of new money, the Fed increases the inflation pressure in the economy.
This means, plain and simple, that the Federal Reserve can actually set a destabilizing process in motion by cutting its federal funds rate further. By the same token, the ECB can return parts of the euro zone to similar, macroeconomically debilitating circumstances. Its latest rate cut reinforces worries that inflation will set deeper roots in the European economy.
It is encouraging to see that Federal Reserve officials have begun voicing hesitation regarding another rate cut. Hopefully, they have drawn the same conclusions from reviewing inflation data as I have, namely that the recent uptick in producer prices will reinforce the rise in consumer prices. The PPI—producer price index—ticked up by a minuscule 0.2% (annual rate) in November, but that increase came on the heels of three months with declining producer prices.
If we look at historical experiences with high inflation—which for the U.S. means going back to the early 1980s—producer prices should be declining at this point in the cycle. The fact that they are not reinforces my concern that there are structural problems in the U.S. economy that prevent inflation from falling below, or even down to, the Fed’s 2% target.
These structural problems consist of reduced competition in numerous markets and industries, resulting from the widespread government-forced shutdown of economic activity in 2020 and early 2021. Many small businesses were wiped out and have not reopened. Larger businesses consolidated to survive, while others yet made so much money during the shutdown—Walmart is an example of a company that was allowed to keep its doors open—that they have had enough fiscal muscle to push competitors out of the market.
European countries that enforced shutdowns have in all likelihood seen the same, or an even stronger, trend of market concentration. This would help explain why consumer price inflation in the euro zone remains high, even as most of the euro zone’s economy is at a virtual standstill.
It will take a concerted effort by legislators on both sides of the Atlantic Ocean to address this structural problem. If that does not happen, the dangers of irresponsible monetary policy from both the Fed and the ECB will be considerably higher, both now and over the long term.
