ECB's Rehn Flags Downside Risks Amid Inflation Stabilization

The European Central Bank has settled at its 2% inflation target, with the Harmonised Index of Consumer Prices (HICP) reflecting price stability across the euro area. However, policymaker Olli Rehn warns that temporary factors may be masking persistent medium-term downside risks. While inflation has fallen sharply from 10.6% in 2022 to 2%, he cautions that real income recovery remains vulnerable to new economic shocks. The ECB emphasizes that localized price pressures and energy cost fluctuations could delay sustained alignment with its goal, requiring vigilant monitoring of wage growth and consumer demand.

Services Drive Inflation's Fragile Stability

Services inflation remains the eurozone's dominant pressure point, accounting for nearly half of household spending at 45.7% and contributing 3.1% to headline inflation in July 2025. This persistent force emerged alongside falling energy costs, which masked broader stability as core inflation climbed to 2.4% in October. The ECB's October assessment flagged services costs as the primary engine behind this core inflation rise, underscoring how pricing power in domestically focused sectors resists disinflationary forces.

Yet this stability masks fragility. Services inflation's sensitivity to wage growth and external shocks-like tariffs or supply chain disruptions-creates vulnerability.

While food and energy volatility remains muted, wage pressures in hospitality, healthcare, and professional services could reignite broader inflation if labor markets tighten further. The ECB's cautious stance, reflected in market expectations of only one potential rate cut by late 2026, hinges on whether these service-sector dynamics remain contained. For now, stability persists, but the sector's structural weight means even modest shocks could disrupt the delicate balance.

Policy Flexibility vs. Market Fragility

The European Central Bank kept rates steady in June 2025, signaling continued flexibility as policymakers navigate persistent economic uncertainties like trade tensions and geopolitical risks. Market participants now price in a 40% probability of a rate cut by 2026, reflecting cautious optimism about the eurozone outlook. However, this policy patience coincides with growing concerns about equity market valuation levels.

ECB Governing Council member Olli Rehn has directly warned that soaring stock prices – partly fueled by AI-driven rallies – risk becoming disconnected from real economic growth, creating potential correction hazards. His concern centers on valuations that appear inflated relative to underlying fundamentals, a situation that could prove fragile if economic data disappoints or inflation proves stickier than expected. While the deposit rate stands at 2%, Rehn cautions that the disconnect between financial markets and the real economy warrants vigilance.

This market fragility exists alongside compliance constraints affecting broader EU initiatives. Rehn has emphasized that financing mechanisms like repurposing frozen Russian assets for Ukraine's recovery must occur outside ECB channels due to Article 122 funding limitations, preventing the central bank from involvement in such political solutions. The ECB's role remains strictly monetary, despite calls for alternative funding approaches.

The current environment demands careful calibration. While inflation has stabilized near the 2% target without triggering mass unemployment, Rehn notes it's likely to remain slightly below that level in the medium term, influenced by lower energy prices and euro strength. Any significant deviation – either upward inflation surprises requiring rate hikes or persistent weakness exposing market vulnerabilities – could test both policy flexibility and financial stability. Investors should monitor whether the AI-fueled equity surge can sustainably outpace real economic growth, as Rehn suggests might not be sustainable.