Euro zone inflation drops more than expected in relief for ECB

June 3, 2023

Euro zone inflation eased more than expected last month as underlying price growth also slowed, fuelling a debate about the need for further European Central Bank rate hikes beyond an increase later this month.

Inflation in the 20 nations sharing the euro eased to 6.1% in May from 7% in April, below expectations for 6.3% in a Reuters poll of economists.

The reading came as only a modest surprise for investors, however, as national data earlier this week foreshadowed the drop.

Core inflation, which excludes volatile food and fuel prices and which has played an increasing role in the ECB’s policy deliberations, fell to 5.3% from 5.6%, coming well under expectations for 5.5%.

The ECB has raised base rates by a combined 375 basis points to 3.25% over the past year to combat runaway prices.

It has also essentially committed to another 25 basis point hike on June 15 given high underlying price pressures.

“Today, inflation is too high and it is set to remain so for too long,” ECB President Christine Lagarde said today.

“That is why we have hiked rates at our fastest pace ever – and we have made clear that we still have ground to cover to bring interest rates to sufficiently restrictive levels.”

Some economists argued that the bigger than forecast drop in underlying inflation suggests that not much work is left to be done.

“Underlying inflation has probably passed its peak,” Commerzbank economist Christoph Weil said.

“This supports our expectation that the ECB will raise key interest rates by 25 basis points for the last time in June.”

Several influential policymakers, including the central bank governors of Germany, the Netherlands and Ireland, have already put a July rate hike on the table, and other economists sided with the policy hawks.

They argue that July must be in play, partly because the ECB has been wrong about the inflation path for so long, it would rather err on the side of caution.

“The May numbers and broader economic data will most likely convince the ECB to continue 25 basis points hikes in June and July and in our baseline forecast to pause after that,” Nordea said in a note.

While today’s benign price data add to the case for caution, Europe’s inflation problem is far from solved as price growth for many core items, particularly services, remains stubbornly high.

Services inflation slowed to 5% from 5.2% while price growth for industrial goods eased to 5.8% from 6.2%, still excessive but both moving in the right direction.

The ECB is also likely to take some comfort from the slowdown in food inflation to 12.5% from 13.5% as pressures on that front were still expected to build for some time.

Lower energy prices could push down headline inflation faster than some forecasts, but recent wage settlements could keep core inflation high.

Euro zone wage growth is hovering in the 5% to 6% range, twice the rate that would be consistent with the ECB’s inflation target.

But wages need to catch up after inflation ate deep into real incomes for years and the ECB is hoping that once inflation slows, wage growth will follow, so they will mutually extinguish each other.

While that is a plausible scenario, the bloc’s labour market is exceptionally tight and firms, particularly in services, are reporting increasing labour shortages, an upside risk for wages and hence inflation.

Another potential concern for the ECB is that economic growth appears less resilient than thought, particularly in manufacturing, with a raft of indicators showing that industrial activity could weigh on the overall economy even as services boom.

This raises the risk that sharply higher borrowing costs could tip the bloc into recession, an outcome the ECB has tried to avoid.

Financial investors see two more rate hikes from the ECB, with the first move fully priced in by June and a second in either July or September.

Euro zone inflation still too high – ECB chief

Euro zone inflation remains too high, so further European Central Bank policy tightening is necessary, even if there is a growing body of evidence that past rate hikes are staring to work, ECB President Christine Lagarde said today.

The ECB has lifted rates by a combined 375 basis points since July and essentially promised another move in June, despite fresh data showing inflation easing far more than expected in May to 6.1%.

“Today, inflation is too high and it is set to remain so for too long,” Lagarde said in a speech.

“That is why we have hiked rates at our fastest pace ever – and we have made clear that we still have ground to cover to bring interest rates to sufficiently restrictive levels,” she added.

These hikes are already raising bank rates “forcefully” and there is still plenty of tightening in the pipeline but the ECB is uncertain just how much stronger the transmission of its policy will be, Lagarde said.

“So, we need to continue our hiking cycle until we are sufficiently confident that inflation is on track to return to our target in a timely manner,” she said, referring to the bank’s medium-term inflation target of 2%.

While many policymakers have already put a July rate hike on the table even before the June 15 meeting takes place, some economists said today’s benign inflation data could mean the end of hikes already this month.

This is still not the main scenario, however, according to investors, who still price two more rate hikes, and policymakers rarely change their views on a single piece of data.

Part of the problem is that underlying price growth is stubbornly high.

“There is no clear evidence that underlying inflation has peaked,” Lagarde said. “Labour markets across the euro area are tight and workers have considerable bargaining power, which they are starting to use to recoup these losses.”

Article Source – Euro zone inflation drops more than expected in relief for ECB – RTE

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