Inflation risks stall ECB pivot expectations

The European Central Bank is entering a tactically sensitive phase of the monetary cycle. While headline inflation continues to decelerate, ECB Executive Board member Isabel Schnabel has warned that inflation risks are “tilted slightly to the upside,” a statement that challenges market expectations for early and aggressive rate cuts. The European economy is weak, but the ECB’s concern is that disinflation may not be linear. Services inflation remains sticky, fiscal deficits are still expansionary in several member states, and real wage growth has finally turned positive. Against this backdrop, the ECB cannot allow financial conditions to loosen prematurely, even as growth momentum remains fragile.

The mechanism behind the ECB’s caution is rooted in wage dynamics. After two years of real income erosion, wage settlements across the eurozone are running in the 4–5% range. Unlike goods inflation, which has collapsed as supply chains normalized, services inflation is tied to labor costs and will only soften gradually. If wage growth remains above productivity gains, unit labor costs stay elevated and flow through to core inflation. Markets have been pricing a rapid pivot based on declining headline inflation alone, but the ECB is problematizing that narrative: rate cuts risk re-accelerating prices through the wage channel if delivered too early. The European Central Bank must therefore balance a weakening economy against a still-elevated inflation floor.

Growth data complicates the decision. Eurozone GDP is hovering around flat to 0.5% annualized, with Germany in a mild industrial recession. However, household purchasing power is improving as inflation falls faster than wages, and fiscal support — particularly in France, Italy, and Spain — remains accommodative. That fiscal impulse effectively offsets some of the drag from monetary tightening. For the ECB, this means the transmission of policy is slower than in the U.S., where fiscal contraction is more visible. Maintaining restrictive rates longer is intended to counteract loose fiscal stances and prevent inflation expectations from drifting.

The bond market response is clear: European sovereign yields remain volatile around macro data releases, and peripheral spreads react quickly to any hawkish ECB language. If the centrale bank signals that inflation could persist, 10-year bund yields can reprice upward and reintroduce divergence across Italy, Spain, and Portugal. For banks, a slower path toward rate cuts preserves net interest margins, but for leveraged corporates and SMEs, prolonged restrictive conditions increase refinancing pressure as more debt rolls into higher coupons in 2025–2026.

For equities, the message is mixed. Financials benefit from carry, but rate-sensitive sectors — real estate, utilities, and discretionary — face higher discount-rate headwinds. What matters for markets is not whether the ECB cuts rates, but when and how quickly. If the ECB delays until it sees sustained services-inflation cooling and sequential moderation in wage growth, the cycle could resemble the 2011–2013 pattern — cautious easing, stop-start communication, and sensitivity to fiscal fragmentation. Investors should focus on unit labor cost data, negotiated wage indicators, and the ECB’s Consumer Inflation Expectations survey.

Forward risks revolve around three variables. First, wage inflation: if settlements remain above 4%, rate cuts will be pushed back. Second, energy volatility: a renewed spike in natural gas prices would transmit quickly through producer prices. Third, fiscal consolidation: if member states resist tightening, the ECB will maintain pressure through restrictive rates. If services inflation finally decelerates and unit labor costs revert to trend, the first cut could occur late in 2025 — but Schnabel’s signaling implies Europe should price a later pivot, not an earlier one. The ECB is protecting credibility first and growth second.