Eurozone inflation is slowing, but underlying price pressures persist

Although Europe’s economy is more robust than many forecasters had predicted, it has still weakened significantly over the past 12 months, with inflation-adjusted wages and consumer confidence falling. Growth is expected to pick up, but further interest rate increases could act as a brake on the economy.

Gita Gopinath, first deputy managing director of the International Monetary Fund, said this week that an “unpleasant truth”[ads1]; was that central banks must be diligent in bringing down inflation rates “even if it means risking weaker growth.”

The same message comes from the ECB, which has already signaled the likelihood of interest rate increases in July and September. At the central bank’s 10th annual conference this week in Sintra, Portugal, Christine Lagarde, ECB president, said: “Inflation in the euro area is too high and will remain so for too long.”

The rapid rate hikes have drawn criticism from political leaders such as Giorgia Meloni, Italy’s prime minister, who scorned “the ECB’s simplistic recipe for raising interest rates” in a speech to parliament on Wednesday.

Lucrezia Reichlin, professor at the London Business School and former director of research at the ECB, said “it would be a mistake” to raise interest rates in September.

“There is a misconception that core inflation is driven by demand,” she said, but the small increase in June is the result of a time lag between the impact of previous rate hikes and significant declines in energy prices.

Riccardo Marcelli Fabiani, an economist at Oxford Economics, said the slight increase in core inflation “does not mean that the deflationary process has stopped”. Service sector inflation fell in France and Italy, he noted, which were among the “increasing signs that deflationary pressures are widening.”

Inflation in the euro zone – whipped up by skyrocketing energy and food prices last year after the coronavirus pandemic subsided and Russia invaded Ukraine – peaked in October at 10.6 percent.

Price increases have slowed throughout the eurozone since then. France’s annual inflation rate fell to 5.3 percent in June, from 6 percent in May. Italy’s interest rate fell to a 14-month low of 6.7 percent, down from 8 percent the previous month. Spain’s rate fell to 1.6 percent, the slowest since March 2021. Government subsidies of gas bills have helped keep the rate low.

Germany, the largest economy in Europe, saw its annual inflation rate rise to 6.8 percent, from 6.3 percent in May. But analysts said the increase was almost entirely due to a reduction in subsidized train fares that the government put into effect last June. Inflation rates in Germany are expected to fall again in September.

Slovakia’s interest rate of 11.3 percent was the highest in the eurozone.

Despite expectations that inflation in Europe will continue to fall, the rate remains well above the central bank’s target of 2 per cent. The effort to reach this goal led politicians to raise interest rates, lifting the deposit rate to 3.5 per cent in June, a 22-year high.

Before it started raising interest rates last year, the ECB’s key rate was negative 0.5 percent.

Lagarde said this week that “this persistence is caused by the fact that inflation works its way through the economy in phases, as different economic actors try to pass the costs on to each other.”

Although economists are often fixated on the risk of a wage-price spiral fueling inflation, there has been growing evidence recently that the pursuit of corporate profits has pumped up prices despite significant falls in energy prices since last year’s peak.

“Rising corporate profits account for almost half of the rise in Europe’s inflation over the past two years, as companies raised prices by more than the cost of imported energy,” economists at the International Monetary Fund said this week.

“Europe’s businesses have so far been shielded more than workers” from rising costs, the IMF noted. Adjusted for inflation, the profit was above the pre-pandemic level, while workers’ compensation was 2 per cent below the trend in the first quarter of this year.

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