Shocking: European Central Bank’s Bold Move to Tighten Monetarily Despite Rising Service Inflation in Euro Zone!

High inflation in services is a new economic phenomenon hitting the euro area and should keep the core consumer price index very high until the end of this year. It could reach close to 4% in December, twice the 2% target pursued by the European Central Bank (ECB) in the medium term.

Among the main reasons are low unemployment, consumer perception that the continent may escape a severe recession in the coming quarters, pent-up demand for travel and tours due to covid-19 and extra savings for families during the pandemic.

Even with the normalization of international supply chains and the substantial reduction in energy and food prices, which rose sharply with the Russian military invasion of Ukraine, core inflation in Europe should remain close to 5.5% in June.

The note is very unsatisfactory for the European Central Bank and justifies the continuation of the restrictive monetary policy started in July. ECB President Christine Lagarde and other ECB officials may raise interest rates in June, July and perhaps September to avoid the risk of a price “spiral” emerging.

The increase in the costs of services, which account for 45% of inflation in the Eurozone, is related to a number of factors. “The significant increases in food and energy seen until recently hit the tertiary sector hard and increased spending on transportation, restaurants and hotels,” said Sebastian Vismara, senior global economist at BNY Mellon Investment Management.

Also determining the strong increase in services, the rise in wages and the transfer of prices by companies to consumers, situations motivated by high inflation.

Nominal compensation per employee rose 5% in the euro zone in the fourth quarter, year-over-year, while inflation reached 10%. Nominal wage negotiations advanced 4.3% in the first quarter, also in the annual comparison, just above the 8% increase in the consumer price index achieved in the period.

“Workers manage to raise wages, but they were far from fully compensating for the reduction in real income caused by inflation, since unions have lost a lot of bargaining power in the last two decades, not only in Europe, but in much of the world. of the world”. said Veronika Roharova, chief eurozone economist at Credit Suisse.

On the other hand, Veronika and some colleagues from Credit Suisse analyzed the behavior of the GDP deflator in the Eurozone in 2022 and found that 60% of last year’s inflation in the region was caused by the increase in corporate profits. . “This fact occurred to a large extent because, with very high inflation, many companies with pricing power acted with some freedom to pass on the increase in costs to consumers in various sectors, such as energy, agriculture and hospitality,” he said. .

less expense

The rise in inflation in the Eurozone reduced disposable income for consumers, but also caused a tightening monetary policy cycle, as the ECB raised interest rates from -0.50% to 3.25% so far , which in turn generated a tightening of the conditions for granting credit.

“Now there is in the euro zone a reversal of the cycle of purchases of durable products, such as electronics, which occurred with great intensity during the pandemic, and is replaced by the great demand for services, whose cost is lower,” he said. Chris Hare, senior European economist at HSBC bank.

Christine Lagarde recently stated that this shift from commercial to European sectors should not affect her tourism plans this summer, as the latest ECB survey of consumer expectations shows. Tourism was the only item with which the European population intends to increase its spending in the coming months.

“In this context of high spending on services such as tourism, core inflation in the euro zone is expected to reach 5.6% in June and decrease slightly until September, when it will reach 5%,” said Christian Schulz, chief economist. Europe deputy for Citi. “Portugal and Spain will register the best season of visitors from other countries in the last three years and there are also good prospects in this segment for Italy and Greece.”

The ECB’s reaction

As the inflation in services worries the ECB a lot, it is very likely that the official institution will raise interest rates by 0.25 percentage points next week and make at least one more increase in July of the same magnitude. However, the opinions of economists in Europe are divided on whether or not to continue with the tightening monetary policy in September.

In the evaluation of Antonio Villarroya, head of the area of ​​macro and strategic studies at Santander Corporate Investment Banking (CIB), the European Central Bank will see a gradual reduction in inflation in September, when it will release macroeconomic projections for the first time in the second half These estimates should show that the consumer price index will return to the 2% long-term target and lead the ECB to end the high interest rate cycle at the 3.75% pa mark.

“The ECB could stop raising rates at that point, as it could increase the chances of going through a recession if it wants to continue monetary tightening to bring inflation quickly from around 3.5% to the target of 2 %”, said. Villarroya. For him, the official institution will begin to cut interest rates in the second quarter of 2024 and will bring them to the neutral rate of 2.5% in December of next year.

Carsten Brzeski, director of the ING bank’s global economics department, also believes that the ECB should suspend interest rate hikes in September, as there will be a clear slowdown in consumption in the euro zone in the second half, motivated by various factors. : Fears rise that Europe could face a sharp economic downturn if the US goes into recession; decline in industrial production on the continent, driven by lower exports of manufactured goods to the US market; and higher savings, as nominal interest rates will be high by eurozone standards.

“Despite this scenario, the European Central Bank will be able to raise interest rates in September because it does not trust its own macroeconomic projections, although it shows that inflation will come down well in 2024,” Brzeski said. “The ECB does not want to risk making a mistake again and falling behind in conducting monetary policy, as it did until mid-2022.”

In the assessment of Sam Cartwright, economist at Société Générale bank, the European Central Bank will raise interest rates by 0.25 percentage points in September, after two similar increases in June and July, because inflation in the euro area, mainly due to the rise in services, tends to remain resilient in the short term. He estimates that the core consumer price index should hit 4.1% in December.

“The ECB should raise interest rates to 4% in September to keep expectations anchored and not allow inflation to take root in society,” Cartwright said. As she forecast the underlying indicator to decline modestly in 2024, when it will close the year at 2.6%, she said the European Central Bank will not lower interest rates next year, but only in 2025.

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