Euro zone inflation drops more than expected but core price growth holds steady

Euro zone inflation eased for the third straight month in January but relief may be limited as underlying price growth held steady and concerns have already been raised about the reliability of the figures.

Inflation in the 20-nation currency bloc fell to 8.5 per cent last month from 9.2 per cent in December data from Eurostat, the European Union’s statistics agency, showed on Wednesday. The figure was well below a Reuters poll expectation for 9 per cent. Irish inflation fell to 7.7 per cent, the Central Statistics Office said on Tuesday.

Price growth has been in rapid decline since peaking at a record 10.6 per cent in October but the European Central Bank (ECB) has already promised more rate hikes, fearing that without higher borrowing costs, inflation could get entrenched above its 2 per cent target.

Meeting on Thursday, the bank is all but certain to raise rates by a half a percentage point to 2.5 per cent and the biggest question is just how much more tightening it will signal.

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The headline inflation drop is unlikely to expunge concerns among conservative policymakers that rapid price growth is getting entrenched, a worry reinforced by poor underlying inflation data on Wednesday.

Excluding food and fuel prices, inflation picked up to 7 per cent from 6.9 per cent while an even narrower measure watched closely by the ECB, held steady at 5.2 per cent, exceeding forecasts for 5.1 per cent.

Underlying inflation was driven by a jump in processed food and industrial goods prices but services inflation eased a touch.

Another issue is the reliability of the data. Unlike in other months, data from Germany, the bloc’s biggest economy, is missing and Eurostat was forced to use a model-based estimate.

January figures are also prone to unusual volatility because of start-of-the-year price changes, economists says.

Conservative policymakers are likely to argue that a milder-than-expected economic downturn will mean a smaller increase in unemployment, so wages will remain under upward pressure and force the ECB to raise rates even more.

Indeed, unemployment held steady at 6.6 per cent in December, its lowest rate on record, separate data showed on Wednesday.

They are also likely to say that core inflation is at risk of getting stuck well above the ECB's 2 per cent target as the second round effects of high energy prices feed through, potentially leading to a self-reinforcing inflation.

Markets now expect ECB rates to peak at 3.5 per cent, the highest rate in more than 20 years, suggesting another 100 basis points of hikes after Thursday’s move.

Policy doves from the bloc's south are likely to fight back, however, arguing that the economy has already started to respond and a bit more time is needed for past policy moves to take effect.

Indeed, bank lending is set for its biggest drop since the bloc’s 2011 debt crisis, Germany and Italy recorded negative growth last quarter and an exceptionally mild winter, not some unpredicted resilience, accounted for better growth figures last quarter. – Reuters