Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Core Inflation Is Running Hot Despite Lower Energy
Transcript
- Lucas: So the ECB meets this week, and markets are pricing in another quarter-point cut — that would bring the deposit rate down to 3.25 percent. But here's the thing: core inflation in the eurozone is still running at 3.8 percent. That's not exactly mission accomplished. Luna: Right — headline inflation dipped to 4.2 percent in May thanks to energy base effects, but strip out food and energy, and it's actually been accelerating. Lucas: Exactly. And the ECB's own projections from March had core inflation at 3.2 percent by the middle of this year. We're well above that. So the question is: why is core so stubborn? And the answer, increasingly, is services. Luna: Services inflation in the eurozone has been stuck around 4.5 percent for months. That's nearly double the overall target. What's driving it? Lucas: Wages. The services sector is labor-intensive — restaurants, hotels, healthcare, personal services — and those wages have been catching up after years of real-terms losses. Look at Germany's construction industry: collective bargaining agreements this year delivered raises between 6 and 8 percent. That feeds through into renovation costs, rents, everything tied to housing services. Luna: And it's not just Germany. Spain's hospitality sector saw wage growth above 5 percent year-over-year in the first quarter. Portugal, too. Lucas: Right. So the ECB has a real communication challenge. President Lagarde is going to have to explain why they're cutting rates even though underlying inflation is still well above 2 percent. The market expects the cut, so not doing it would be a shock. But doing it risks looking like they're easing too early. Luna: Is there a way they can finesse it? Signal a pause after this one? Lucas: Probably. They'll lean heavily on the forecast — they'll update their staff projections this week, and those will likely show core inflation drifting back toward 2.5 percent by late 2027. But that's a long way off, and the data between now and then could easily go the other way. Luna: The euro has already weakened — it dipped below $1.15 on the day the US CPI came in hot. A weaker euro makes imported goods more expensive, which could actually add to inflation pressures. Lucas: That's the bind. If the Fed holds rates higher for longer while the ECB cuts, the euro-dollar spread widens, the euro falls, and that puts upward pressure on import prices. Services inflation stays sticky, goods disinflation gets partly offset by currency effects. The ECB's job gets harder, not easier. Luna: So what's the actual risk here? That we get a stagflationary-type scenario — low growth, sticky inflation? Lucas: Not full 1970s stagflation, but a milder version — what some economists call 'slowflation.' GDP growth in the eurozone is around 1.6 percent annualized, which is hardly booming. And if core inflation stays near 3.5 percent, then real interest rates are actually pretty tight. The ECB might be cutting, but if inflation doesn't fall, the real rate stays restrictive. Luna: And the labor market is still tight. The eurozone unemployment rate is at a record low — 6.2 percent — so workers have bargaining power. Lucas: That's the key structural factor. The labor force is shrinking in many eurozone countries due to demographics. So even with moderate growth, employers have to compete for workers. That keeps wage growth elevated. And wage growth in services is stickier than in goods — you can't easily automate a haircut or a hotel room. Luna: I saw a fascinating breakdown from the Bundesbank showing that if you strip out energy and food, the biggest contributor to core inflation in Germany is actually housing services — rents, maintenance, utilities. That's up 4.8 percent year-over-year. Lucas: And that's partly a supply problem. Construction costs have surged, partly from those wage increases we mentioned, partly from material costs. Fewer new apartments are being built. So rental inflation feeds directly into the services CPI component. And that's not something the ECB can fix with interest rates — that's a housing policy issue. Luna: Exactly. Which brings us back to the ECB's credibility problem. They can only do so much when the inflation is coming from supply-side constraints. Lucas: And that's the conversation Lagarde will have to have this week. She'll acknowledge that services inflation is persistent, but she'll argue that the overall disinflation path is intact. Markets will parse every word for hints of a September cut, or a pause. Luna: If walking through the economy with us has made something click — especially around these inflation dynamics — the show stays ad-free thanks to listeners like you. If today was worth a coffee to you, that's the link: buy me a coffee dot com slash fexingo. No pressure, just appreciate you being here. Lucas: Second that. It genuinely helps us keep digging into these details. So — back to the data. One number I'm watching closely is the eurozone producer price index, which just came in for April. Luna: What did it show? Lucas: Producer prices fell 1.2 percent month-over-month, driven by energy. But core producer prices — excluding energy — actually rose 0.3 percent. That's the second consecutive monthly increase. What that tells me is that pipeline pressures for core goods are starting to re-emerge. Luna: So even though headline PPI is falling, the underlying trend for non-energy goods is turning up. That's not great for the inflation outlook. Lucas: No. And if that feeds into consumer goods prices over the next few months, then the ECB's forecast for core inflation to drift lower becomes harder to defend. The market's already pricing in a slower pace of cuts for 2027. Luna: What's your baseline for this week? Do they cut or hold? Lucas: I think they cut. The forward guidance is already heavily tilted toward a cut, and surprising markets would cause unnecessary volatility. But I expect a very cautious tone — maybe even a signal that this is the last cut for a while unless data improves. Luna: So a hawkish cut. That's become a theme this year across central banks. Lucas: Exactly. The Bank of England did it in May. The Fed isn't cutting at all yet. The ECB wants to support growth, but they can't ignore the inflation data. So they give a quarter-point, but they talk tough. Luna: What would change the narrative? What number would force their hand in either direction? Lucas: If core inflation surprises to the upside in June or July — say, above 4 percent — they'd have to pause. Conversely, if we see a sharp drop in services inflation, maybe from a cooling labor market, they could accelerate cuts. But right now, the labor market isn't cooling. Luna: So we're in a waiting game. Watching wage deals, watching services CPI, watching the euro. Lucas: And that's the story for the rest of 2026. The ECB is trying to normalize policy, but the last mile of inflation is proving to be the hardest. Services inflation is the final boss, and it's not going down without a fight. Luna: Final boss — I like that. Alright, we'll be watching Thursday's decision closely.