ECB’s interest rate plans in flux as euro-zone inflation drops more than expected

Euro-zone inflation eased more than expected last month as underlying price growth also slowed, backing arguments for only cautious further rate hikes as the fastest ever European Central Bank monetary tightening cycle starts to take effect.

Inflation in the 20 nations sharing the euro eased to 6.1 per cent in May from 7.0 per cent in April, below expectations for 6.3 per cent 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 per cent from 5.6 per cent, coming well under expectations for 5.5 per cent.

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The figures show headline inflation in the Irish economy fell to 5.4 per cent in May on the back of falling energy prices but core inflation unexpectedly rose to 5.7 per cent, keeping the pressure on households.

The ECB has raised base rates by a combined 3.75 percentage points to 3.25 per cent over the past year to combat runaway prices.

But with underlying price pressures having built throughout 2023 even as overall inflation has been on a declining path, the central bank has essentially committed to another quarter-point rate hike on June 15th.

Several influential policymakers, including the central bank governors of Germany, the Netherlands and Ireland, have also put a July rate hike on the table, but there is wide agreement that the outlook beyond that is too murky to commit.

ECB vice-president Luis de Guindos said on Thursday that, while the bank had gone through most of its monetary policy tightening to bring inflation back to its medium-term target of 2 per cent, the cycle was not quite over yet.

While Thursday’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 5.0 per cent from 5.2 per cent, while price growth for industrial goods eased to 5.8 per cent from 6.2 per cent, 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 per cent from 13.5 per cent as pressures on that front were still expected to build for some time.

“The European inflation outlook is highly affected by two opposing drivers,” ING economist Carsten Brzeski said.

“Lower-than-expected energy prices due to the warm winter weather are likely to push down headline inflation faster than recent forecasts suggest,” he said. “On the other hand, recent wage settlements and still decent pipeline pressure in services are likely to keep core inflation high.”

Euro-zone wage growth is hovering in the 5 per cent to 6 per cent 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.

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. – Reuters