Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Eurozone Inflation Is Sticky Where the ECB Cant Reach
Transcript
- Lucas: So the headline eurozone inflation number keeps coming down — we're now just inside the ECB's target corridor. But if you peel back the skin on that number, there's a stubborn core that the central bank is really struggling to reach. I'm talking about services inflation, which is running above 4 percent in France and Spain right now, and shows no sign of budging. Luna: And the ECB's rate hikes should have filtered through by now — we're what, eighteen months past the last increase? Why is services still this hot? Lucas: That's the question, and it gets to something that a lot of market commentary glosses over. The ECB's transmission mechanism works well for goods — higher rates crush demand for furniture, cars, electronics. But services are different. A lot of services inflation is driven by labour costs, and labour costs are driven by wage negotiations that were set when inflation was at 8 or 9 percent. Luna: So the wage catch-up is still feeding through, even as the economy slows. Lucas: Exactly. And this isn't a cyclical thing that will resolve in a quarter or two. The ECB's own staff projections show services inflation staying above 3 percent through the end of next year. That's structural stickiness. Look at what happened in Japan in the 1990s — once services inflation gets embedded through wage settlements, it takes years to grind out, even with tight policy. Luna: But Japan had deflation for decades. We're not talking about deflation here — we're talking about 3 or 4 percent, which is above target but not crisis-level. Lucas: Right, and that's the dilemma for Lagarde. If you keep rates high to crush that services stickiness, you risk tipping Germany into recession — its industrial output is already down 2 percent year-over-year. If you cut rates too early, you risk re-anchoring inflation expectations above target, which is exactly what the Fed did in the 1970s. Luna: There's also a geographic dimension here. Northern Europe — Germany, Netherlands — their services inflation is actually closer to 2.5 percent. The heat is concentrated in France, Spain, and Italy. That makes the 'one size fits none' problem even worse for the ECB. Lucas: That's a really important point. The eurozone's inflation divergence isn't just headline versus core — it's north versus south, goods versus services. The ECB can't cut rates for France while keeping them high for Germany. And the trade-weighted dollar has been climbing — it's at 119.3 as of mid-May — which is pushing EUR/USD back toward 1.16. A weaker euro actually imports more inflation through energy and raw materials, which complicates the services picture even further. Luna: So the currency channel is working against them right now. Lucas: It is. And that's the kind of cross-current that makes the June meeting genuinely interesting. The market is pricing a 25-basis-point cut, but I think there's a non-trivial chance they hold steady, just to see if the services data softens over the summer. Luna: What would it take for services inflation to actually break lower? Is it just a matter of time until the wage catch-up is complete? Lucas: Partially, but there's also a structural shift happening. Post-pandemic, labour is scarcer across Europe. The working-age population is shrinking in Germany, Italy, and Spain. That gives workers more bargaining power, which means wages are likely to stay elevated even as the economy slows. So the old playbook — raise rates, crush demand, wages follow — doesn't work as cleanly when labour supply is the constraint. Luna: That's a really good way to frame it. So the ECB is facing something closer to a supply-side inflation in services, not demand-pull. And monetary policy is a demand-side tool. Lucas: Exactly. You can't raise rates to create more workers. You can't raise rates to fix demographic decline. The transmission mechanism breaks down when the bottleneck isn't demand but labour. And that's why I think the conversation at the ECB is shifting from 'how high' to 'how long' — how long do we need to keep rates restrictive to grind out this structural stickiness? Luna: Before we go deeper into the policy outlook — Lucas, you mentioned the demographic piece. Can we talk about what that actually looks like in the data? Because I think a lot of listeners hear 'working-age population shrinking' and it sounds abstract. Lucas: Sure. Let me give you a concrete example. Italy's working-age population has declined by about 3 million people since 2010. That's roughly 5 percent of its workforce. And those aren't evenly distributed — they're concentrated in the north, in manufacturing and services. So you have hotels in Florence or restaurants in Milan that simply cannot find staff, even at higher wages. That pushes up service prices structurally. Luna: And those higher wages then become the baseline for next year's wage negotiations, because workers expect their pay to keep up with the cost of living. Lucas: That's the feedback loop the ECB is trying to break. But breaking it without causing a recession is the hard part. If you look at the real GDP data — the eurozone grew at an annualised 2 percent in the first quarter, which is actually decent. But that's heavily driven by services. Goods-producing sectors are flat to negative. So if you squeeze services demand to cool inflation, you might tip the whole economy into contraction. Luna: Right. And the ECB's mandate is price stability, not growth. But the political pressure to avoid a recession is real, especially with French and German elections looming. Lucas: That's the subtext of every ECB meeting right now. Lagarde has been very careful to say the ECB is data-dependent, not politics-dependent. But the reality is that a prolonged period of high rates in a slowing economy creates political backlash. You're already seeing it in France, where President Macron has been publicly calling for the ECB to consider growth more carefully. Luna: And the market is pricing in a cut in June. If the ECB doesn't deliver, what happens? Do we get a sell-off in bonds? Lucas: Probably not a sell-off, but a repricing. Bund yields would likely rise — not because the market expects tighter policy, but because the market would have to recalibrate the terminal rate higher. I think a hold would actually be a signal that the ECB is serious about grinding out services inflation, and the market would respect that. You might see a 10 to 15 basis point move in the two-year Schatz, but nothing catastrophic. Luna: Let's talk about what the alternative path looks like. If the ECB cuts in June and services inflation stays sticky, do they then pause for the rest of the year? Lucas: I think that's the most likely scenario, actually. A cut in June, then a long pause through the summer and into autumn. The ECB will want to see the fall wage round before committing further. And that wage round will be critical — if unions accept lower nominal increases because headline inflation is down, then the stickiness might start to fade. If they keep pushing for 5 or 6 percent, the ECB will have to keep rates high well into 2027. Luna: Before we wrap up, I want to bring in something from the recent headlines. There was a piece about consumer sentiment hitting a record low in the US, tied to war-driven inflation fears. Does that spill over into Europe? Lucas: It does, but in a different way. European consumers are less exposed to direct energy price shocks now than they were in 2022, because natural gas storage is full and the winter is over. But the indirect channel — through trade, through confidence, through higher shipping costs — that's real. And a weaker euro relative to the dollar compounds it. So even if the ECB cuts rates, the currency channel might keep import prices elevated, which feeds into services inflation through things like imported food and beverages in restaurants. Luna: It's like there's no clean exit ramp. Every path has complications. Lucas: That's exactly right. And I think the honest answer from the ECB is: we're going to have to live with inflation around 2.5 to 3 percent for at least another year, maybe two, while the structural adjustments play out. The question is whether the market and the political system can tolerate that without demanding drastic action. Luna: Alright, Lucas — let's leave it there for today. Thanks for unpacking that, really helpful. Lucas: Thanks, Luna. And for those listening, if today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. We'll be back tomorrow with another episode. Luna: Yeah, it really does make a difference. Thanks for being part of this. Lucas: See you next time.