Why it matters
While the European economy is more resilient than many forecasters predicted, it has continued to weaken significantly over the past 12 months, with inflation-adjusted wages and consumer confidence falling. Growth is expected to pick up, but further interest rate rises could put a brake on the economy.
Gita Gopinath, the first deputy director of the International Monetary Fund, said this week that an “inconvenient truth” was that central banks must remain diligent in cutting inflation rates “even if it means risking weaker growth.”
The same message comes from the ECB, which has already signaled the likelihood of rate hikes in July and September. Speaking at the central bank’s 10th annual conference this week in Sintra, Portugal, Christine Lagarde, the president of the ECB, 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 on Wednesday denounced “the ECB’s simplistic recipe for raising rates” in a speech to Parliament.
Lucrezia Reichlin, a professor at the London Business School and former director-general of research at the ECB, said “it would be a mistake” to raise 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 timing gap 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 deflation process has stopped.” Service sector inflation fell in France and Italy, he noted, which were among “increasing signs that deflationary pressures are intensifying”.
Eurozone inflation — pushed up last year by high energy and food prices after the coronavirus pandemic eased and Russia invaded Ukraine — peaked at 10.6 percent in October.
Since then, price increases across the eurozone have slowed. Annual inflation in France fell from 6 percent in May to 5.3 percent in June. Italy’s rate fell to a 14-month low of 6.7 percent, down from 8 percent the month before. The Spanish rate fell to 1.6 percent, the lowest since March 2021. Government subsidies on the gas bill have helped keep the rate low.
Germany, Europe’s largest economy, saw annual inflation rise from 6.3 percent in May to 6.8 percent. But analysts said the increase was almost entirely due to a reduction in subsidized train fares introduced by the government in June last year. Inflation in Germany is expected to decline again in September.
At 11.3 percent, Slovakia’s rate was the highest in the eurozone.
Despite the expectation that inflation in Europe will continue to fall, the rate remains well above the central bank’s target of 2 percent. Efforts to meet that goal led policymakers to raise interest rates, pushing the deposit rate to 3.5 percent in June, a 22-year high.
Before the ECB started raising interest rates last year, the key policy rate of the ECB was 0.5 percent negative.
Why is inflation so stubborn?
Ms Lagarde said this week that “this persistence is caused by the fact that inflation gradually works its way through the economy as different economic actors try to pass the costs on to each other.”
While economists are often fixated on the risk of a wage-price spiral fueling inflation, there has recently been mounting evidence that the pursuit of corporate profits is driving up prices, despite significant declines in energy prices since last year’s peak.
“Rising corporate profits are responsible for nearly half of the increase in European inflation over the past two years, as companies have raised prices by more than just the cost of imported energy,” economists at the International Monetary Fund said this week.
“European companies have so far been better protected than workers” against rising costs, the IMF noted. Adjusted for inflation, earnings were above pre-pandemic levels, while employee compensation was 2 percent below trend in the first quarter of this year.