Eurozone Inflation’s Falling. It Might Not Be Enough.

Eurozone Inflation’s Falling. It Might Not Be Enough.
Stéphane Renevier, CFA

8 months ago2 mins

Eurozone inflation stats were released Friday, and while you may feel like cheering the latest numbers, you’ll want to keep the bigger picture in mind.

Good news first: Overall or “headline” inflation cooled off more than predicted in June, with prices rising just 5.5% from their levels a year ago. That’s the smallest jump since the start of the war in Ukraine. You can tip your hat to lower food and energy prices for this welcome decline.

But don’t break out the champagne just yet: inflation is still stubbornly above the European Central Bank’s (ECB's) 2% target, and it might take a long time to get it back to a more comfortable zone. With food and energy prices coming down from their sky-high levels, the easy wins in the inflation tournament are likely behind us. If those prices stay where they are or – heaven forbid – start climbing again, further drops in headline inflation would be more difficult to achieve.

But here's the kicker: “Core” inflation, which excludes more volatile items like food and energy prices, has actually risen compared to last month. Sure, some technical factors might have played a role, like government subsidies that temporarily pushed prices lower a year ago (and as a result biased the year-over-year comparison), but it’s still a bit of a downer. That’s not only because core inflation is a stickier beast – making it a more reliable gauge of longer-term inflationary pressures – but also because it suggests that the ECB's interest rates might not be high enough – even at these levels. With the prices of services rising, and the labor market still too hot, there are risks that inflation won’t slow as fast as people expect.

This puts the ECB in a tight spot, with mounting pressure to hike rates higher (central banks have a better grip on core components like services and wages than they do on food and energy prices, after all). And the longer we're stuck with high interest rates, the more credit will shrink, the more consumers and companies will come under pressure, and the bigger the blow to future economic growth. And since rate hikes tend to take their own sweet time to impact the economy, we're probably not out of the woods yet. So while it's great to see inflation falling – and it still is dropping fast enough to potentially cushion the landing – we're walking a fine line. Proceed with caution.

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