Why is falling inflation unlikely to deter the ECB from further rate hikes?

Why is falling inflation unlikely to deter the ECB from further rate hikes?

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Euro-zone inflation fell back into single digits in December, with data released Friday morning showing the headline rate hit 9.2 percent after annualized price growth topped 10 percent in the previous two months.

Nor the slower likely won’t be enough to convince the European Central Bank to halt rate hikes for now, as markets are still pricing in a slew of hikes by Frankfurt officials later in 2023.

Franziska Palmas, senior Europe economist at research group Capital Economics, said: “The ECB is likely to stick to its hawkish rhetoric in the near term, despite the big dips – and the likelihood of further sharp declines this year.”

Why aren’t the falls enough to convince the ECB to change course?

While falling fuel prices and government subsidies to support businesses and households with higher electricity bills have lowered headline inflation rates, underlying price pressures remain strong.

Berlin paid most households’ gas bills for December, which was 1.2 percentage points below the harmonized rate of headline inflation, according to estimates by Commerzbank economists. The rate fell to 9.6 percent from 11.3 percent in the previous month. But service cost growth, an indicator of how long price pressures are likely to persist, accelerated in December.

Line chart of annual percentage change showing that German headline inflation is falling but underlying pressures remain

In Spain, core CPI inflation – which excludes food and energy price movements – rose to 5.6 percent year-to-date through December, despite a stronger-than-expected decline in the harmonized headline rate.

Although headline inflation in the euro zone fell to 10.1 percent in November from a record 10.6 percent in October, core inflation remained at an all-time high of 5 percent. It is expected to stay there in December.

“This year will be all about getting to the bottom of inflation and what’s driving it,” said Paul Hollingsworth, chief economist for Europe at French bank BNP Paribas.

For the ECB to change course, rate-setters will anticipate a significant fall in the core interest rate and other indicators of longer-term inflationary pressures, such as inflation. B. Wage growth. They will also be on the lookout for signs that government support for homes and businesses struggling with high energy prices is spurring demand.

Christine Lagarde said in one interview told the Croatian newspaper Jutarnji List: “We have to be careful that the domestic causes [of inflation] that we see, which are mainly related to fiscal measures and wage dynamics, do not lead to inflation taking hold.”

What next for inflation in Europe?

After the decline in energy prices since the beginning of the year, further declines are expected in the coming months. The impact of last year’s increase in electricity costs following the Russian invasion of Ukraine will also soon disappear from the index, significantly reducing the headline count.

Carsten Brzeski, head of macro research at Dutch bank ING, predicted that euro area inflation could even fall back to the ECB’s 2 percent target by the end of 2023.

If the recent drop in gas prices continues, the ECB will almost certainly have to revise its inflation forecast for this year downwards. The central bank said in December that prices would rise 6.3 percent over the course of 2023, based on the assumption that natural gas prices will average €124 per megawatt-hour for the full year.

But the price of the Dutch TTF benchmark gas contract for Europe fell about 10 percent this week to just €69.70/MWh on Thursday afternoon – a level 80 percent below the August high of €340/MWh.

“The ECB’s own inflation forecasts are currently too high, judging solely from the technical assumptions for gas and oil prices and their current prices,” Brzeski said.

What does this outlook mean for interest rates?

Last year, the ECB responded to rising inflation by raising interest rates at an unprecedented pace, raising its deposit rate from minus 0.5 percent in July to 2 percent by the end of the year.

ECB President Christine Lagarde said in December that markets had underestimated how much higher borrowing costs would rise, adding: “We should expect to hike rates at a pace of 50 basis points for some time.”

Since then, investors have priced in rate hikes of around 1.5 percentage points in the first three quarters of 2023.

Two half-notch hikes at the next two policy officials’ meetings in February and March, and some smaller moves later in the year remain the expectation, despite this week’s stronger-than-expected fall in inflation.

Line chart of expectations for the deposit rate level up to September 2023 (%), showing that markets still expect the ECB to hike rates aggressively

Barring a stronger decline in measures of underlying price pressures, market and economist expectations for euro-zone interest rates are unlikely to change much.

“It’s all very well going back to 3 or 4 percent inflation,” Hollingsworth said. “But getting to 2 percent could be harder, especially if there’s a milder-than-expected recession.”

He added: “We really need to see service prices and wage growth cool down to convince the ECB that it has done enough.”

Additional reporting by Valentina Romei

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