Stubborn core inflation means rate rise is inevitable

There had been little doubt that the European Central Bank (ECB) would increase interest rates by half a point on Thursday. Now there is none at all.

While the fall in euro zone inflation from 9.2 per cent in December to 8.5 per cent in January did point to some decline in general inflationary pressures, the so-called core rate of inflation – excluding food and energy – remains stuck at 5.2 per cent.

This is more than enough evidence of ongoing inflationary pressures for the ECB to move on Thursday, pushing its deposit rate up to 2.5 per cent and bringing the total increase in interest rates since the rises started last July to a hefty three percentage points.

Another half point rise is widely expected in March and there are not so subtle hints from senior ECB figures of at least one more thereafter.

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The euro zone inflation data was better than market analysts had anticipated – most anticipated a 9 per cent annual rate. The main reason for the decline is easing pressure on energy prices as wholesale gas costs continue to fall.

Elsewhere inflationary pressures remain, though service price inflation eased a bit. There was enough in the figures to provide evidence to both camps – those who feel inflation will stay stuck above target levels for a prolonged period and those who expect a sharp reduction this year.

Conceivably both could be correct – the inflation rate could fall sharply but remain above the 2 per cent ECB target.

Data earlier in the week showing that euro zone growth remained in positive territory will further encourage the ECB to keep increasing interest rates.

But this also brings us to the centre of the problem. How much demand does the ECB have to knock out of the euro zone economy to get inflation back to its 2 per cent target?

Given the cause of inflation this time – mainly spurred by supply-side factors – the trade off between growth and inflation looks tricky. There may not be too much political reaction to this week’s ECB rise across Europe, but that could change by March.