Eurozone Inflation Surprises Upwards, ECB Rate Cut Still on Track, but Further Easing Under Scrutiny

Euro zone inflation unexpectedly rose in May, signaling a more protracted path towards the European Central Bank’s (ECB) 2% target. While this development is unlikely to derail the anticipated interest rate cut next week, it might prompt a pause in July and a slower pace of easing in the coming months.

The flash estimate from Eurostat revealed a 2.6% year-on-year increase in consumer prices for the 20 countries sharing the euro, surpassing economists’ expectations of a 2.5% rise. This marks a slight acceleration from the previous two months, when inflation held steady at 2.4%.

The upward surprise was partly attributed to unfavorable comparisons with last year, when Germany implemented temporary measures such as subsidized rail travel.

Despite the higher-than-expected reading, ECB policymaker Fabio Panetta, governor of the Bank of Italy, downplayed its significance, reiterating his view that multiple rate cuts were still possible without compromising economic stability.

However, a more concerning development was the increase in core inflation, excluding volatile items like food and energy, which rose to 2.9% from 2.7% in April. Notably, prices in the services sector, a key indicator of domestic demand, rebounded to 4.1% from 3.7%. This rise likely reflects the larger-than-expected wage increases in the first quarter, boosting consumer spending power after years of below-inflation pay hikes.

The ECB’s aggressive rate hike campaign has successfully curbed inflation from its peak of 10% in late 2022, primarily driven by surging energy prices following Russia’s invasion of Ukraine. While the hikes have stabilized consumer inflation expectations, they have also tightened credit conditions.

Despite growing market doubts about the global disinflation narrative, policymakers are expected to adhere to their well-telegraphed plans for a rate cut next week. However, the latest inflation and wage figures might lead to a reevaluation of the subsequent easing pace.

Market analysts now anticipate a slower pace of rate cuts, with the possibility of back-to-back reductions in July becoming less likely. Nevertheless, two more rate cuts before the end of the year are still expected if the downward inflation trend resumes in the third quarter.

Following the inflation data release, German government bond yields, the benchmark for euro zone borrowing costs, surged to their highest level in over six months. Markets are currently pricing in around 57 basis points of ECB rate cuts in 2024, suggesting a 25 basis point cut in June and one more by year-end. However, expectations for a third cut this year have been gradually diminishing.