Euro zone Inflation at Record High. What Next?
Euro zone inflation rose to a new record high of 5.1% in January, significantly above the Bloomberg consensus of 4.4%. The ECB’s position is that current price pressures are temporary, but this unexpected rise in the Eurozone price level will increases the pressure on the European Central Bank to abandon this narrative at its regular monetary policy meeting tomorrow.
The ECB president, Christine Lagarde, has repeatedly said that interest rates won’t rise in 2022 so a change in stance would see a sharp rise in term interest rates. The euro would almost certainly rise too. The single-currency has fallen out of favour in recent weeks as the market moved to price in 5 rate increases for both the US and UK this calendar year, widening the spread to euro rates.
Over the past 10 years, inflation in the EU has largely set below the ECB’s target of 2%, with the regular threat of deflation prompting the ECB to introduce negative interest rates in 2014 to help stabilise inflation close to their target. However, official interest rates at -0.5% seem incompatible with inflation soaring to all-time highs for the Eurozone. Pre- 2008, when inflation was stable at/ above 2%, the 2yr fixed rate set between 2.15% and 5.5% incongruous. Currently, it’s trading below zero.
As recently as 6 months ago, financial markets were pricing in no change in interest rates until June 2025. The market has now pulled forward the timing of an initial rate hike to this December even though the ECB position going into tomorrow’s meeting remains that rates won’t change in 2022. The ECB’s stance runs contrary to the position taken by the Bank of England who are expected to increase rates by 0.25% tomorrow and the USA’s Federal Reserve where the market chatter is around whether interest rates will need to rise by 0.50% instead of 0.25% at its next meeting in March. The ECB has argued that wage growth, a precondition of durable inflation, is still muted and underlying price growth is weak. However, with unemployment now running at a historic low of 7% and still falling, the risks are that wage inflation will increase as the labour market continues to tighten.
ECB policymakers meeting on Thursday are almost certain to keep policy unchanged. However, Lagarde now faces pressure similar to that faced by other central bankers to amend the level of interest rates in the Eurozone. Markets will be paying close attention to each word that’s said at tomorrow’s press conference.