Eurozone inflation fell back to single digits in December, with data published on Friday morning showing the headline rate reached 9.2 percent after annual price growth exceeded 10 percent for the previous two months.
But the slowdown was not enough to convince the European Central Bank to stop raising interest rates, as markets are still pricing in several increases by officials in Frankfurt through 2023.
Franziska Palmas, senior European economist at research group Capital Economics, said: “The ECB is likely to keep its hawkish rhetoric in the near term despite a major downturn – and a sharper decline is likely this year.”
Why was the fall not enough to convince the ECB to change tactics?
While lower fuel prices and government subsidies to help businesses and households with higher electricity bills have reduced inflation, underlying price pressures remain strong.
Berlin paid the most for household gas bills for December, which Commerzbank economists estimated subtracted 1.2 percentage points from the harmonized headline inflation rate. The rate fell to 9.6 percent, down from 11.3 percent the previous month. But the growth in the cost of services, an indicator of how long price pressure is likely to endure, accelerated in December.
In Spain, the core CPI inflation – which does not include movements in food and energy prices – rose in the year to December, although it fell more sharply than expected in the harmonized headline rate to 5.6 percent.
Although headline inflation in the eurozone fell from a record 10.6 percent in October to 10.1 percent in November, core inflation – at 5 percent – remained at an all-time high. It is expected to remain in December.
“This year will be more about inflation and looking at exactly what’s driving it,” said Paul Hollingsworth, chief European economist at French bank BNP Paribas.
For the ECB to change tack, rate-setters will want to see a substantial fall in the core rate and other measures of long-term inflationary pressures, such as wage growth. They will also be looking for signs that government support for households and businesses struggling with high energy prices is boosting demand.
Christine Lagarde said in an interview with the Croatian newspaper Jutarnji List: “We have to be careful that the cause is domestic [of inflation] what we see, which is mainly related to fiscal measures and wage dynamics, does not lead to inflation becoming stable.
What’s next for inflation in Europe?
Further declines are expected in the coming months, following the reduction in energy prices since the beginning of the year. The impact of last year’s rise in electricity costs following Russia’s invasion of Ukraine will also be missing from the index, lowering the headline figure substantially.
Carsten Brzeski, head of macro research at Dutch bank ING, predicted that euro area inflation could even fall back to the ECB’s 2 percent target by the end of 2023.
If gas prices continue to fall, the ECB will almost certainly have to lower its inflation projections for this year. The central bank said in December that prices would rise by 6.3 percent during 2023, based on the assumption of an average natural gas price of €124 per megawatt hour during this year.
But the price of the Dutch TTF European gas contract has fallen by around 10 percent this week to just €69.70/MWh on Thursday evening – a level 80 percent below August’s high of €340/MWh.
“The ECB’s own inflation projections are now too high, just judging from the technical assumptions for gas and oil prices and where those prices are now,” Brzeski said.
What does this outlook mean for interest rates?
Last year, the ECB responded to rising inflation by raising interest rates quickly, lifting the deposit rate from minus 0.5 percent in July to 2 percent by the end of the year.
ECB President Christine Lagarde said in December that the market was underestimating higher borrowing costs, adding: “We should expect to raise interest rates at a pace of 50 basis points for some time.”
Since then, investors have priced in around 1.5 percentage points of rate hikes over the three quarters of 2023.
Two half-point rate hikes at the next policy meetings of officials in February and March and some minor moves at the end of the year remain expectations, despite sharper-than-expected inflation this week.
Without a sharper fall in underlying price pressures, market and economists’ expectations of eurozone interest rates are unlikely to change significantly.
“It’s all very well going back to 3 or 4 percent inflation,” Hollingsworth said. “But it may be harder to get down to 2 percent, especially if there is a milder-than-expected recession.”
He added: “We really need to look at the price of services and the cooling of wage growth to convince the ECB that it has done enough.”
Additional reporting by Valentina Romei