Euro Zone Inflation at 2.6% as ECB Struggles to Stabilise Prices

In May, Euro zone inflation experienced an uptick, as reported on Friday, signaling that the European Central Bank (ECB) faces a prolonged and uncertain path towards achieving its goal of stabilising prices.

This larger-than-expected rise in inflation is unlikely to deter the ECB from reducing borrowing costs from their record high in the upcoming week.

However, it might support a pause in July and a more measured approach to interest rate reductions in the subsequent months. Dirk Schumacher, an economist at Natixis, commented that these figures bolster the argument for a cautious approach.

According to Eurostat’s preliminary estimate, consumer prices in the 20 countries using the euro increased by 2.6% year-on-year in May.

This marks a slight movement away from the ECB’s 2% target, following increases of 2.4% in the previous two months.

Economists surveyed by Reuters had predicted a rise to 2.5%, partly due to unfavourable comparisons with the previous year when Germany had implemented subsidies for rail travel and other one-off measures.

ECB policymaker Fabio Panetta, who is also the governor of the Bank of Italy, described the latest inflation figures as neutral, reiterating his stance that the central bank could afford multiple rate cuts while still maintaining economic restraint.

A particularly notable measure of core inflation, which excludes volatile items such as food, energy, alcohol, and tobacco, rose to 2.9% in May from 2.7% in April.

Prices in the services sector, identified by some policymakers as a key indicator of domestic demand, climbed to 4.1% from 3.7%.

This rise is likely a reflection of unexpectedly high wage increases in the first quarter, which have helped restore some of the consumers’ disposable income eroded by years of wage growth lagging behind inflation.

The ECB’s unprecedented series of rate hikes has played a crucial role in reducing inflation, which had peaked at 10% in late 2022 due to soaring energy prices following Russia’s invasion of Ukraine.

These rate hikes have not only stabilized consumer inflation expectations but have also led to a significant tightening of credit. As a result, policymakers are expected to adhere to their plans to cut rates in the forthcoming meeting, despite increasing market skepticism about a global trend towards declining inflation.

Diego Iscaro, head of European economics at S&P Global Market Intelligence, stated that the recent inflation and wage data decrease the likelihood of consecutive interest rate cuts in July. However, he anticipates two more ECB rate cuts before the year ends, provided the downward trend in inflation continues in the third quarter as expected.

Following the release of the inflation data, German government bond yields, a benchmark for euro zone borrowing costs, reached their highest level in over six months.

Currently, markets are pricing in approximately 57 basis points of ECB rate cuts in 2024. They anticipate a 25 basis point cut in June, with another expected by year-end. However, recent weeks have seen a gradual reduction in expectations for a third rate cut this year.

In summary, the recent inflation data indicates that the ECB’s journey to achieve price stability remains slow and uncertain.

While the immediate effect may not alter the planned rate cut next week, it does highlight the need for a cautious and measured approach in the coming months.

Policymakers will have to balance the ongoing inflation pressures with the economic impacts of their monetary policy decisions.