Eurozone inflation hits single digits: Time to celebrate or brace for more rate hikes?

nflation in the Eurozone fell to 9.2% in December, according to the flash index of consumer prices among the 20 European member countries. This marks a decline from the 10.1% rate in November and a record high of 10.6% in October.

While this is a positive development, underlying price pressures remain high, with the gauge excluding volatile energy, food, and fuel prices reaching a new high of 5.2%. This highlights the concerns of policymakers that lower petrol and energy prices will bring down the headline rate without addressing underlying inflationary pressures.

European Central Bank's response to inflation

The ECB is expected to continue aggressive interest rate hikes to address underlying inflationary pressures. Markets are still pricing in a series of increases by the ECB throughout 2023. The ECB has already pledged to lift its deposit rate beyond its current level of 2%.

Bank of France chief Francois Villeroy de Galhau has indicated that the peak for borrowing costs may only be reached toward the summer, after which the ECB will be "ready to remain at this terminal rate as long as necessary". 

ECB Governing Council member Martins Kazaks expects "significant" increases at the next two meetings in February and March.

The ECB is likely to focus on underlying price pressures and measures of longer-term inflationary pressures, such as wage growth, as it pushes ahead with the most aggressive bout of interest-rate hikes in its history. However, there are concerns that the fiscal measures and wage dynamics being implemented by governments to support households and businesses struggling with high energy prices could boost demand and lead to entrenched inflation. 

President Christine Lagarde has warned against solely paying attention to changes in Europe's headline inflation rate, stating that there are valid reasons to anticipate an increase in price growth in January. She emphasized that "we cannot be fixated on one single number".

Impact of gas prices on inflation projections

The ECB has assumed that natural gas prices will average €124 per megawatt hour over 2023. However, the cost of the Dutch TTF benchmark European gas contract has fallen about 10% this week to just €69.70/MWh, which is 80% below the August high of €340/MWh. This could lead the ECB to downgrade its inflation projections for the year. 

In the short term, the unusual warmth has eased concerns about an energy shortage and brought gas prices back to pre-war levels. However, it is predicted that the Eurozone will only experience a short and mild recession, which could result in sustained demand and potential inflation.

Factors contributing to high underlying price pressures

Growth in the cost of services, an indicator of longer-term price pressures, accelerated in December. When the cost of services increases, it can indicate underlying inflationary pressure in the economy, which may persist even after temporary factors such as energy price spikes have subsided.

If the cost of services rises faster than overall inflation, it can signal that demand for services is outstripping supply, further contributing to price pressures. In the case of the Eurozone, the acceleration in growth in the cost of services in December suggests that there may be persistent underlying inflationary pressures that need to be addressed by the ECB through its monetary policy measures.

Core inflation in the Eurozone is expected to remain at an all-time high of 5% in December. These high underlying price pressures concern policymakers. They suggest that current inflation is not just a temporary phenomenon driven by factors such as supply chain disruptions or energy price spikes.

Potential future developments in Eurozone inflation

Further falls in energy prices are expected in the coming months, which could lead to a decline in headline inflation. The impact of increased power costs due to Russia's invasion of Ukraine is expected to no longer be reflected in the index, leading to a significant decrease in the headline figure.

Some analysts predict that Eurozone inflation could drop back to the ECB's target of 2% by the end of 2023. If the recent falls in gas prices continue, the ECB will almost certainly have to downgrade its inflation projections for this year. However, it is crucial to remember that the current low-interest rates and the high levels of government support for households and businesses could lead to demand-driven inflation in the longer term. 

The ECB will need to carefully balance the need to support the recovery with the need to contain inflationary pressures.

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