Eurozone inflation exceeds expectations, what will the ECB do?

I wrote on Wednesday about how optimism had increased in the wake of weaker than expected inflation data from France. Markets rose as investors turned to today, when the euro zone’s all-important inflation figure would be released, in hopes that the positive French reading could indicate that today would also bring some friendlier news.

Eurozone inflation better than expected

They got their way. Inflation in the euro area came in at 9.2%, lower than expected at 9.5%. Last month’s reading was 10.1%, representing a healthy decline of 90 basis points and moving back into single digits.

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Core inflation remains high

But hold off on popping the champagne, because it’s not all good news.

Core inflation, which excludes more volatile food and energy products, rose to a new high of 5.2%. This means that falling gas prices are driving the total figure down (9.2%), but the underlying causes of the cost of living crisis remain, as can be seen in the increasing number of key figures.

Traditionally, it is this key issue that politicians pay attention to. Monetary policy is geared toward this metric, as food and energy are too volatile and dependent on too many variables to be within the control of central banks, as became abundantly clear last year with the invasion of Ukraine, which drove up energy prices.

Looking at the chart below paints a very different picture, showing that the uptrend continues.

What will the ECB do?

With core inflation still rising and well above the 2% target outlined by the ECB, a further program of interest rate tightening is needed. Interest rates are currently at 2% – well below what is seen across the Atlantic as the Federal Reserve has passed 4% – and analysts had expected a further rise to 3.5% this week.

With four interest rate hikes carried out by the ECB last year, the Eurozone is already facing a recession. The area has come under intense strain in the wake of Russia’s invasion of Ukraine, with both an energy crisis and a cost-of-living crisis gripping countries across the bloc.

The Stoxx 600, a stock market index that captures 90% of market capitalization in 17 countries, lost nearly 13% last year. Looking at selected individual countries, Germany’s DAX fell more than 12%, France’s CAC 40 fell 9.5% and Spain’s IBEX 35 fell 5.7%.

The news stems from ECB President Christine Lagarde’s aggressive tone in December:

“We don’t turn, we don’t falter, we show determination.”

The stock markets proceed cautiously

European shares were cautious immediately after the news. The Stoxx 600 was flat, appreciating the decline in headlines but refusing to move up because of its stubborn core.

The index is up 2.5% so far this year, and expectations appear to be priced in that inflation would be worse than it has been. The index posted three consecutive days of positive moves earlier this week.

The eyes will now be on the United States. US non-farm payrolls are expected today before the all-important CPI figure is due next week.

2022 was summed up by equity markets diverging from central banks’ interest rate policy decisions as policymakers struggled to bring inflation under control. 2023 started the same way. There is still a long way to go and it looks like this will be the case for at least the first half of the year.

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