Inflation in the Euro zone has reached a new high, bolstering the case for large ECB rate hikes

Inflation in the euro zone hit yet another record high in May, casting doubt on the European Central Bank’s belief that gradual interest rate rises beginning in July will suffice to slow stubbornly high price growth.

Inflation in the eurozone’s 19 member countries surged to 8.1 percent in May, exceeding estimates of 7.7 percent, as price increases broadened, showing that it is no longer primarily energy that is driving up the headline figure.

Prices have risen dramatically across Europe in the last year, owing to supply chain issues following the pandemic and then Russia’s war in Ukraine, indicating that a new era of rapid price increases is sweeping away a decade of ultra-low inflation.

Despite the fact that headline inflation is now four times the ECB’s two percent target, ECB policymakers may be more concerned by the quick rise in underlying prices, which imply that what was formerly considered as a temporary increase in prices is now being embedded.

Inflation omitting food and energy prices, which the ECB constantly monitors, increased to 4.4 percent from 3.9 percent in April, while a narrower measure that also excludes alcohol and tobacco increased to 3.8 percent from 3.5 percent in April.

In order to contain inflation, ECB President Christine Lagarde and chief economist Philip Lane have already indicated that the ECB’s minus 0.5 percent deposit rate will be increased by 25 basis points in July and September.

However, several officials and economists worry that this will be sufficient, particularly given underlying inflation shows no indications of abating.

The issue is that once high energy costs enter the system, inflation spreads out and becomes entrenched, eventually perpetuating itself through a price-wage spiral.

While the evidence for such a trend is still lacking, a slew of indicators, ranging from a rise in negotiated salaries to expanding core inflation, point to an increasing danger.

As a result, the central bank governors of Austria, the Netherlands, and Latvia have all stated that a rate hike of 50 basis points should be considered in July.

The director of the Dutch central bank, Klaas Knot, even said that inflation expectations are now at the top end of what can still be characterised as anchored, implying that households and investors may soon begin to doubt the ECB’s commitment to slowing price growth.
On June 9, the ECB will hold its next meeting, where it will formally halt a bond-buying programme at the end of the month and continue to signal rate hikes.