Euro zone inflation jumps, cooling case for ECB rate cuts

Euro zone inflation surged last month and could still go higher in the early part of 2024, easing financial markets pressure on the European Central Bank to start cutting interest rates from record highs.

Inflation across the 20-nation bloc jumped to 2.9 per cent in December from 2.4 per cent in November, just shy of expectations for a 3 per cent reading, mostly on technical factors, such as the end of some government subsidies and low energy prices getting knocked out of base figures.

The data appear to confirm the ECB’s prediction that inflation bottomed out in November and will now flatline in the 2.5 per cent to 3 per cent range through 2024, still well above the bank’s 2 per cent target, before slowing again in 2025.

In a hopeful sign, however, underlying inflation – defined as price growth excluding food and energy – eased to 3.4 per cent from 3.6 per cent, suggesting that price pressures are still cooling even as the headline number jumped.

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Still, policymakers may be concerned that services inflation jumped 0.7 per cent on the month and the annual reading held steady at 4 per cent as this is closely tied to wages and may be pointing to a quick rise in incomes, which could then fuel further price pressures.

The inflation jump comes as investors and policymakers appear to be drawing vastly different conclusions about price trends and their implication for interest rates.

Investors are betting that the ECB will cut rates six times this year – with the first move coming in March or April – as an economic contraction and benign wage growth ease inflation, letting the bank unwind its fastest policy-tightening cycle on record.

But policymakers argue that price pressures remain abundant and crucial wage settlements will not conclude until the first quarter of this year, so it might take until mid-2024 to gain the confidence that inflation is indeed under control. In fact some even argue that market rates have eased so much that investors have undone some of the ECB’s work, forcing the bank to keep rates high even longer to get the sort of economic restriction that cools price pressures.

A key source of the divergence in views is that the ECB’s own inflation projections have been off for years, suggesting that the bank does not have a full understanding for price-setting behaviour in exceptional circumstances. First it predicted just a transitory rise in prices, then a shallower peak, and finally a much slower reversal, fuelling some policymakers to raise their focus on fact figures and lower the emphasis on projections.

Investors argue that the ECB is too optimistic on growth and also point to a sharp drop in producer prices – down 8.8 per cent in November – as evidence of cooling price pressures.

Finally, markets are also betting on aggressive rate cuts from the US Federal Reserve. And investors think that once the world’s biggest central bank moves – in March or May – the ECB will want to move in sync.

However, unexpected strength in the US jobs market in December, when it added 216,000 jobs against advance projections for a fall on November’s numbers to around 170,000 jobs, undermines the case for the Federal Reserve to consider cutting interest rates soon.

ECB projections unveiled in December see inflation still at 2.6 per cent in the final quarter of this year, then hitting 2 per cent in the third quarter of 2025 and eventually settling at 1.9 per cent.

The ECB will next meet on January 25th, and the bank has clearly signalled that no policy action is coming at that meeting. – Reuters