Eurozone Inflation Drops, ECB Considers Balance Sheet Reduction

December 01, 2023 22:20

The European Central Bank (ECB) has been accused that it delayed taking any action against inflationary pressures that were observed in the autumn of 2021. The debate still rages on as some analysts suggest that quick action could have limited inflation’s rise and could have prevented the eurozone’s central bank from leading interest rates so high.

While headline inflation has been falling in the last few months, core inflation remains at higher levels. Even though inflation drops, it doesn’t seem to deter the ECB from suggesting that the monetary policy could become even tighter in the future.

ECB Considers Balance Sheet Reduction

In the last few days, the ECB’s policymakers have revealed that they consider reducing the eurozone central bank balance sheet earlier than anticipated. The ECB’s balance sheet is full of bonds that were bought during the last financial crisis and the pandemic period to pour funds into the European markets that were struggling.

Joachim Nagel, a member of the ECB's board, said that the central bank of the eurozone should reduce its balance sheet. This could be done by selling a lot of bonds that have been stored there for a few years. Economists think that reducing the ECB's balance sheet would make the market supply go up and interest rates stay high for longer, which would make the single currency stronger against the US dollar.

Christine Lagarde, ECB's head, told the European Parliament (EP) that the bank might talk about stopping the last of its bond purchases earlier than planned in order to speed up the reduction of the balance sheet. Some ECB officials have said they support this because they think that buying bonds adds to the price pressures in the euro bloc. It's important to know that the Federal Reserve and the Bank of England are no longer buying bonds.

Quantitative Tightening Or Balance Sheet Normalisation

Selling a number of bonds or not reinvesting in them would create an oversupply and a drop in their prices as the existing demand would likely not be able to absorb them. Economists call this process “quantitative tightening” and they note that reducing the balance sheet could have the same impact as raising interest rates. For example, when the Federal Reserve decided to shrink its balance sheet in August 2023, some analysts said that a reduction of $1tn would be equal to raising borrowing costs by 0.25%. The ECB’s balance shrinking could strengthen the euro against the US dollar and the British pound.

Eurozone CPI Inflation Drops In November More Than Expected

Flash CPI inflation estimates in Spain and France came in lower than anticipated in November while headline inflation recorded a 2.4% rise surpassing analysts’ expectations.

ING analysts noted: “They point to a larger-than-expected drop in today’s eurozone flash estimate. For the European Central Bank, that means 2024 could bring a first rate cut. Whether this will be as early as the market currently prices remains questionable though. A first rate cut is close to being fully discounted now for April. Overall, some 110bp in cuts are discounted for the year as a whole.”

Economists at Deutsche Bank Research stressed that inflation figures recorded a larger drop than expected including core inflation that had remained stubbornly high despite the ECB’s efforts during the previous months. Speaking to media reporters, they said that “for the third month in a row, Euro Area inflation surprised markets and forecasters strongly on the downside today. The November inflation flash prints confirmed price pressures are coming down quickly across all components of the inflation basket. This print confirms that Euro Area domestic inflation is slowing much faster than anticipated by ECB forecasts a few months ago.”

A report by Commerzbank was less optimistic regarding interest rate cuts in the eurozone. Analysts at the German bank wrote that: “In the Euro Area, inflation fell by 0.5 percentage points to 2.4% in November, a much stronger decline than expected. The sharp fall in the inflation rate for services was particularly surprising. Core inflation even fell from 4.2% to 3.6%. Today's price data is likely to fuel speculation that the ECB will soon cut its key interest rate. However, we think it is too early to declare victory over inflation, given the strong rise in wages.”

Trading the Euro And Risk Management

As a beginner trader you may have seen again and again the euro to US dollar (EUR/USD) and the euro to the British pound (EUR/GBP) currency pairs in trading news as they are among the most popular currency combinations. 

However, before adding these currency pairs to your portfolio, you should always remember that trading involves risk. A smart way to counter your lack of knowledge around trading as a beginner is to start studying it. Browsing the internet, you may find a large quantity of quality educational materials that you can read or watch such as articles, how-to guides, webinars or other educational videos prepared by experienced traders. If these materials come from a regulated broker, you make sure that the information you receive is up to standard.

As you start your trading learning journey, you shouldn’t neglect learning more about risk management tools. When utilised properly, risk management tools reduce the danger of losing funds in case markets turn against your plans. Of course, this doesn’t mean that you shouldn’t study your trading strategy in depth before executing, but risk management tools can be valuable assets when building it. Learning how to use risk management tools in trading should be one of the first goals for every beginner trader who wants to be prepared for market downturns.

Does trading on macroeconomic news interest you? Learn how this approach works with our free webinars. Meet and interact with experienced traders. Watch and learn from live trading sessions.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Miltos Skemperis
Miltos Skemperis Financial Content Writer

Miltos Skemperis’ background is in journalism and business management. He has worked as a reporter on various TV news channels and newspapers. Miltos has been working as a financial content writer for the last seven years.