Eurozone inflation hits 2.6% in first rise this year

Eurozone inflation rose for the first time this year, to 2.6 per cent, in a troubling sign for investors hoping that the ECB will cut interest rates aggressively this year.

The increase in consumer prices across the single currency zone in the year to May was up from 2.4 per cent in the previous month and slightly above the level forecast by economists in a Reuters poll.

Core inflation, which strips out energy and food to give an idea of underlying price pressures, accelerated from 2.7 per cent to 2.9 per cent. 

Until this month, Eurozone inflation had been gliding gently down towards the ECB’s 2 per cent target all year, allowing policymakers to clearly signal they expect to start cutting the benchmark rate from its record high of 4 per cent next week.

Germany’s 10-year bond yield — a benchmark for Eurozone borrowing costs — jumped to 2.7 per cent in response to Friday’s data, its highest level for more than six months.

The ECB is still widely expected to go ahead with next week’s rate cut, which would make it the first major central bank to ease monetary policy since the biggest inflation surge for a generation started three years ago. 

Some of the more dovish members of the ECB’s rate-setting governing council downplayed the significance of the rise in inflation in May. Italian central bank governor Fabio Panetta said it was “neither good nor bad”, while Portugal’s central bank head Mário Centeno said it was “not a significant deviation” from expectations and would not prevent the ECB from starting to cut rates.

But with price pressures picking back up again this month and the Eurozone economy returning to growth in the first quarter, investors expect the ECB to adopt a more cautious approach to lowering rates for the rest of this year.

Some policymakers have warned that higher inflation readings will make the ECB less likely to make a back-to-back cut in July. Markets are pricing in between two and three 0.25 percentage point rate cuts this year.

Jack Allen-Reynolds, an economist at Capital Economics, said the jump in Eurozone inflation “won’t stop the ECB from cutting interest rates next week. But another reduction in July is now looking unlikely.”

ECB chief economist Philip Lane told the Financial Times earlier this month that “barring major surprises” the central bank was likely to remove the top level of restriction at its meeting next week in Frankfurt. 

He said the pace of further cuts would depend on the path of underlying inflation and the level of demand, which he warned was likely to be “bumpy and gradual”. 

Eurozone inflation was lifted by energy price growth turning positive for the first time in over a year, at 0.3 per cent in May.

The ECB expects Eurozone wage growth to slow from recent record highs and companies to absorb higher labour costs by compressing profit margins instead of passing them on to consumers via price rises.

This will be crucial in determining how quickly inflation in the labour-intensive services sector comes down this year. In May, Eurozone services inflation rose to a seven-month high of 4.1 per cent, up from 3.7 per cent a month earlier.

Yet some economists see one-off factors behind the recent rise in services inflation, including this year’s earlier timing of Easter and the fading disinflationary impact of Germany’s discounted public transport ticket.

“The rise in service price inflation is not a welcome development,” said Diego Iscaro, an economist at S&P Global Market Intelligence, adding he would wait for detailed data to show “if the end of German transport subsidies was the main culprit or if there were other factors boosting service prices”.

There are signs that consumers remain cautious despite their purchasing power being boosted by wages rising faster than inflation this year. German retail sales fell 1.2 per cent in April from a month earlier, separate figures on Friday showed, while French retail sales fell 0.8 per cent in the same period.