While there is much debate in this country about whether Germany is the ailing man of Europe or not, the economy in Slovenia is growing. In the fourth quarter, gross domestic product (GDP) climbed by 1.1% compared to the same period last year. This is the highest figure in the eurozone. Germany, on the other hand, is facing a second consecutive year of economic contraction in 2024. This has only happened once since the end of the Second World War.

The differences between the individual euro countries in terms of inflation are currently even more pronounced than in terms of economic growth. Since November, inflation in Italy has been well below 1%. In the Baltic States, on the other hand, consumer prices are continuing to rise rapidly. Statisticians recently recorded an inflation rate of 5.0% for Estonia, for example.

"We are currently experiencing a phase in which there are exceptionally large differences between the individual euro countries in terms of economic and inflation trends," says Timo Wollmershäuser, Head of Economic Research and Forecasts at the Ifo Institute. "These differences make life more difficult for the ECB." This is because the European Central Bank (ECB) bases its monetary policy on the inflation trend in the eurozone as a whole. However, the greater the spread of the country's data, the higher the probability that the monetary policy is not the right one for a larger number of member states. While the ECB's monetary policy will – hopefully – help to reduce the eurozone's inflation rate to 2.0% in the medium term, it is too restrictive for some eurozone countries and too expansionary for others.

Countries with higher inflation rates have lower real interest rates. This increases economic activity. This, in turn, further increases price pressure. Countries with lower inflation rates, on the other hand, have correspondingly higher real interest rates. The effect of monetary policy on the local economy is, therefore, precisely the opposite. The ECB's problem: The differences in inflation and economic growth have many different causes, but the central bank can really influence none of them. "The ECB has to accept the differences," summarises Wollmershäuser.

One reason for this is the different economic structures in the countries. For example, the German economy has suffered more from the rise in energy prices as a result of the Russian war of aggression in Ukraine – the second anniversary of which falls on Saturday – than other euro countries. On the one hand, this is due to the relatively large energy-intensive industrial sector in Germany. On the other hand, dependence on cheap Russian energy imports was high at the time.

In addition to financial stability, the respective national fiscal policy also influences economic growth and inflation in the country. "Fiscal policy in Germany applies the brakes more strongly than in other countries," says Wollmershäuser. If the Federal Republic were to overturn the debt brake and spend more, this could strengthen the economy in Germany but, at the same time, increase inflation. Not a desirable scenario for the ECB. It repeatedly appeals to national governments in the eurozone to consolidate their budgets and not to pursue an expansionary fiscal policy. Politicians also influence inflation in the country in other ways, for example, when they adopt price caps. In 2022, for instance, a whole series of euro countries decided on a state-imposed maximum price for energy.

Last but not least, the ECB's monetary policy also affects countries to different degrees and at different speeds. Central bankers must keep this aspect in mind. After all, this has a significant impact on the development of GDP growth and inflation for the currency zone. "Long-term mortgage loans with a fixed interest rate are common in Germany and France, which is why interest rate changes by the ECB do not have the same impact here as they do in Spain and Italy, for example," says Konstantin Veit, portfolio manager at Pimco, citing an example. He adds: "The larger the construction sector and the capital-intensive industries in a country, the greater the impact of interest rate hikes on the economy."

Wollmershäuser cites the construction sector as one of the reasons why the German economy is currently weak. "The turnaround in interest rates has slowed down the construction sector in Germany more than in other countries, as the market was more overheated in this country." While there was a slowdown in the property sector in other euro countries in the wake of the financial crisis, this only occurred in Germany with the turnaround in interest rates.

Another reason why the ECB's interest rate policy does not have the same effect in all countries is the financial sector. "In Italy, corporate bonds hardly play a role in financing. Companies here mainly finance themselves via bank loans," says Alessandro Tentori, Chief Investment Officer (CIO) for Axa Investment Managers in Southern Europe. In Germany and France, on the other hand, the capital market plays a more significant role in corporate financing.

Savings and lending rates at banks differ despite standardised key interest rates for the entire eurozone. In addition to monetary policy, the competitive situation also plays an important role here. The greater the competition between banks, the greater the impact of the ECB's interest rate changes on the conditions offered by banks.

The structures in the labour market also vary from country to country. For example, the average validity of collective wage agreements, the prevalence of one-off payments to employees and the exact figures analysed by national statistics offices differ. All of this makes it difficult to forecast how wage growth will develop in the near future. However, many members of the ECB Governing Council currently consider this to be the critical factor in determining how quickly the inflation target of 2% can be achieved.

It is, therefore, no coincidence that the ECB has developed a forward-looking wage tracker this year. This includes data on wage agreements in Germany, France, Italy, Spain, the Netherlands, Austria, and Greece. Special payments are also taken into account. "The labour market data in Europe is a mess because it is not harmonised. The ECB has done an excellent job here with the development of the wage tracker to get a better picture of wage trends in the eurozone," summarises Tentori. The ECB's forecasting tool currently assumes high wage growth, which will stabilise in 2024.

The central bankers are aware that their monetary policy does not have the same effect on all euro countries. The Bundesbank addressed this issue in September 2023 in an essay entitled "Heterogeneous effects of monetary policy in the eurozone?". It analysed the effects of the ECB's monetary policy on Germany, Spain, France, and Italy. The conclusion: "It turns out that changes in key monetary policy interest rates have stronger effects on real gross domestic product in Germany and weaker effects in Spain. In contrast, consumer prices react most strongly in Spain and weakest in Germany."

Looking at the 20 countries in the currency area, it is clear that the ECB will never be able to implement the perfect monetary policy for everyone. For Ifo researcher Wollmershäuser, the economic heavyweights have an advantage, even if they only have one vote in the ECB Governing Council, just like the smaller countries. "Monetary policy is more appropriate for Germany than for the smaller eurozone member states. It would have to fluctuate more for them." This is because the economy in small countries is more dependent on individual sectors. In large economies, on the other hand, developments in the individual sectors of the economy are more evenly balanced, meaning that the economy fluctuates less.

Another reason why the large countries in the currency zone have an advantage is their weight in the development of euro inflation and the euro economy. For example, the German figures have a much greater influence on the data of the eurozone, which are significant for the ECB's monetary policy, than those of Slovenia, for example. It is, therefore, evident that the ECB's forecast for price trends in Germany is ultimately more relevant than the Slovenian forecast. In addition, the German economy has a more substantial impact on the economic situation of other countries than is the case for small economies.

Country data, therefore, definitely play a vital role for the European Central Bank, as the Bundesbank also writes in its article from September 2023. "In addition to models at the aggregate euro area level, the Eurosystem also uses various multi-country models that capture differences in the interdependencies when preparing monetary policy decisions." For Wollmershäuser, however, the extent to which the country data ultimately influences the interest rate decision is "one of the great mysteries of ECB monetary policy".