Eurozone inflation rose to 2.4% in December, marking the third consecutive month of rising inflation and well above the low point of 1.7% in September.
Although inflation is now above the ECB's 2% target, the situation is far from alarming. Consumers and investors should not fear a repeat of the inflation crisis of 2022-2023. The rise in recent months may prove to be a temporary boost. This is due to technical effects, as last year's drop in energy prices is now dropping out of the index calculations.
Retail investors also see inflation as less of a threat to their investments. A year ago, 25% of retail investors rated inflation as the biggest risk, while the latest eToro Retail Investor Beat survey among 10.000 investors from December shows that just 19% now see it as the primary risk.
But it may be too early to drop all inflation worries. Even if overall inflation is at an acceptable level, there are components of inflation that are still too high.
Services inflation has stabilised at around 4% for over a year with no clear signs of coming down. Services account for around 70% of the European economy and employment. Historically, there is a close correlation between services inflation and wage growth, and with the European labour market remaining solid, it may take time for lower wage growth to lead to lower services inflation.
While the ECB is likely to see through the temporary uplift in inflation, the persistently high services inflation creates a more complex situation. This could lead to a slower pace of interest rate cuts than expected just a few months ago, when the policy rate could not come down fast enough to support the economy.
The market still expects significant interest rate cuts in the eurozone in 2025. The current policy rate of 3.0% could be lowered by 0.25 percentage points at each interest rate meeting in the first half of the year, bringing the rate down to around 2.0%. However, these expectations may be too optimistic if service inflation remains high.
While Europe's economic growth challenges are well recognised and stock prices already reflect this, the biggest risk to European equities in 2025 is the return of stagflation concerns. Stagflation, which implies no growth while (service) inflation remains too high, could limit the ECB's ability to deliver the accommodative monetary policy the continent so desperately needs to restore growth.
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