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The inflation fight proceeds, slowly

Jumana Saleheen, Europe chief economist, on the inflation and monetary policy outlook in the U.K. and euro area.

Jumana Saleheen: The trajectories for the euro area and the United Kingdom economies have played out largely as we envisioned in the Vanguard Economic and Market Outlook for 2023. High inflation has required higher central bank policy interest rates and has constrained growth.

What has surprised us is the degree of resilience we’ve seen, especially in the labor markets and inflation. Inflation has been stickier than we expected and has required the European Central Bank and the Bank of England to raise policy interest rates higher than we had anticipated.

Inflation has been especially sticky in the United Kingdom. Headline inflation appears to have peaked now, despite troubling high food prices, but core inflation has continued to rise higher, driven by persistently strong demand for services amid relatively high wage growth. 

In the euro area, the war in Ukraine sent energy prices soaring last year. That has taken a toll on the region, sending the euro area into recession in the first quarter of 2023. However, the fall in natural gas prices since the start of this year to levels seen around 18 months ago has been welcome news. It has boosted optimism and resilience in the near-term economic outlook for both the euro area and the U.K.

But the inflation challenges remain, and the interest rate increases required to get inflation back to target are likely to weigh on growth from this point onwards. We don’t anticipate interest rate cuts until well into 2024 in either the euro area or the U.K.

And that’s because it takes time for those higher interest rates to effectively reduce demand by limiting the amount of money and credit in an economy. In areas including the U.K. mortgage market, this transmission is taking longer than in previous cycles. But make no mistake, the transmission of monetary policy is happening slowly but surely. Labor markets are starting to show signs of loosening across Europe.

The inflation outlook brightens through 2024. We see both headline and core inflation falling back towards ECB and Bank of England target levels, allowing for a loosening of interest rates and supporting a modest pickup in growth.