Is the Eurozone gearing up for higher inflation?

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BrusselsReport.eu
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By Gaudrimas Burčius 

Last year, the European Central Bank (ECB) made a significant change to its monetary policy, ending the intensive monetary tightening from 2022 onwards and focusing on the recovery of the stagnating euro area economy in mid-2024. However, despite the proclaimed victory over inflation, the risk associated with cheap money has not disappeared: the amount of currency in circulation has started to increase again, which could again lead to price rises.

In order to curb inflation, which has been unprecedented for a long time, the ECB has adopted a rather tight monetary policy, raising base rates by as much as 4% points in just over a year from mid-2022 and ending quantitative easing. This has led to a rapid decline in the amount of money in circulation. At its peak, in Q3 2023, the money supply in the market fell by 10% compared to the same period a year earlier.

While the 2% inflation target for 2024 has been reached, another problem has emerged: the high cost of borrowing has begun to sting the continent’s already limping economy. According to preliminary estimates, Germany remained in recession for a third consecutive year in 2024, while other major economies such as France and Italy are struggling to achieve GDP growth rates of 1%. The outlook for the euro area itself is also modest, with GDP growth of just 0.8%.

After tightening, a new round of monetary expansion

Last year, the ECB turned to monetary easing in response to the economic slowdown. The money supply indicator M1, which includes cash in circulation and overnight deposits, rose by 2.2% to €10.6 trillion in December. Meanwhile, M3, which alongside M1 includes time deposits and funds held in the form of short-term debt securities, grew at a slightly faster pace of almost 4%, or €16 trillion. On 30 January this year, the Governing Council of the ECB decided to cut base rates by a further 25 basis points (the rate for main refinancing operations is now 2.9%, the rate for marginal lending facilities is 3.15% and the rate for deposit facilities is 2.75%). This could lead to a further increase in the money supply.

In Lithuania, a similar monetary policy trend has been observed — but the magnitude of the changes is much larger. Over the past year, M1 and M3 have risen by 11% and 12% respectively. In December 2024, M1 stood at almost €48 billion and M3 at €58 billion. In the first half of the year, money supply growth rates were more modest, but then picked up quite rapidly, especially in the fourth quarter, with both M1 and M3 rising by more than 2% per month.

Risks to price growth: is the ECB’s course leading to inflation again?

An increase in the quantity of money inevitably contributes to an increase in the overall price level. Easy money does not create new value — it only temporarily stimulates today’s consumption at the expense of the future. When the increase in money is not reciprocated by the creation of new value, it leads to a decrease in the purchasing power of each monetary unit, which raises the general price level.

In October 2024, the ECB reached its 2% inflation target, but the increase in money has not stopped — inflation reached 2.4% in December and is projected to rise to 2.5% in January. A similar pattern is evident in Lithuania, though the rate of growth is more pronounced: in October, Lithuania was close to the deflationary threshold, but a couple of months later inflation reached 1.9%, and in January this year it reached 3.6%.

These indicators suggest that while inflation has been contained, further monetary easing could fuel it again. If money growth does not slow down, inflationary pressures will persist and the ECB may have to tighten policy again. This will undoubtedly create new challenges for the euro area economy.

Gaudrimas Burčius is a Junior Expert at the Lithuanian Free Market Institute

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