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Industrial Policy

UPDATED: Eurozone new inflation record adds pressure on ECB

FRANKFURT – Eurozone inflation surged to a record high of 8.6 percent in June, racing ahead of expectations once again and adding pressure on the European Central Bank to step up its fight against spiralling prices, flash Eurostat data showed today.

A Reuters poll of analysts had pointed to a record 8.4 percent jump in June, up from 8.1 percent in May.

Scorching inflation continues to be primarily driven by energy prices, which were up 41.9 percent in June compared with 39.1 percent in May. That’s followed by food, alcohol and tobacco prices, which were up 8.9 percent in June compared with 7.5 percent in the previous month.

Core inflation, which strips out volatile components and is seen as a good indicator for underlying price pressures, eased slightly to 3.7 percent in June from 3.8 percent in May.

Among member states, the Baltics remain the hardest hit, with inflation hitting 22 percent in Estonia, 20.5 percent in Lithuania and 19 percent in Latvia. The lowest inflation rates were recorded in Malta (6.1 percent) and France (6.5 percent).

The fresh upside surprise in inflation may ratchet up ECB rate hike expectations.  The ECB has been signalling that it will raise interest rates by 25 basis points in July and followed by another, possibly larger move in September.

But Friday’s reading is likely to increase calls for a bolder hike already in July and makes a larger move in September almost certain.

That’s already the expectation in markets, which have priced in more than 140 basis points of tightening until year-end. “We think that ECB is going to hike interest rates by 25 [basis points] in July and will deliver an accumulated 150 [basis points] in hikes by the end of year,” said Oxford Economics analyst Mateusz Urban. With the ECB meeting four more times, that means it would hike each time, in some cases more than 25 basis points.  

Friday is also first day the ECB no longer adds bonds to its balance sheet, leaving its total holdings just short of €5 trillion euros, or 40 percent of eurozone GDP. However, for now it’ll continue to reinvest maturing bonds bought under its various programs.

The ECB will also start to exercise flexibility reinvesting proceeds from bonds bought under the pandemic program to help contain difference in borrowing costs between eurozone member states. In practice, this means that the ECB could buy an Italian bond using the cash from a maturing German bond.

The move was prompted by the recent bond market rout that sparked fears the sovereign debt crisis could return with a vengeance. Since flexible reinvestments are not seen as sufficient to thwart a sovereign debt crisis, the ECB also pledged to design a new to limit so-called bond spreads, or the difference in bond yields between member states.

The risks of a renewed debt crisis is just one headwind the ECB is facing. There are also mounting concerns that the repercussions from the Ukraine war on the eurozone’s doorsteps could push the currency union into a recession.

So even though the signs are pointing to faster tightening now in the face of inflation, the ECB may ultimately be forced into another U-turn and abort those efforts, economists warn.

Among them is Berenberg economist Holger Schmieding, who now expects eurozone GDP to contract by 0.8 percent next year, rather than expand by 2.1 percent as suggested by latest ECB forecasts. Others, including UniCredit’s Erik Nielsen and EFG Bank’s Stefan Gerlach, agree that a recession is now more likely than not.

“If we are right with our calls for a eurozone recession, the ECB will have to revise its outlook substantially again in December,” Schmieding said. “Although inflation at that time will likely exceed the ECB’s current projections by a significant margin again due to even more elevated gas prices, the recession should lead to a faster and bigger fall in inflation thereafter.”

Urban agreed that given mounting risks to growth, there may be no further hikes in the first half of next year.

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