Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / How Eurozone Services Inflation Is Ripping Apart
Transcript
- Lucas: So services inflation in the Eurozone is running at 4.8 percent year-over-year as of May. That is basically double the headline rate, and it is not budging. Luna: And the ECB has to be tearing its hair out, because this is the part of inflation that is most tied to domestic wages and least responsive to interest rate hikes. Lucas: Exactly. When energy spiked in 2022, the mechanism was straightforward — higher rates crushed demand, energy prices fell, inflation cooled. Services are different. A lot of services pricing is about labour costs, and labour costs are still accelerating. Luna: So where is that wage pressure hitting hardest? I know we talk about a North-South split a lot, but is it showing up in services too? Lucas: It really is. Germany's services inflation is around 5.2 percent, driven by hospitality — hotels, restaurants — where wages have risen sharply because the sector couldn't find workers. In Italy, services inflation is closer to 4.1 percent, but that's still well above target, and it's being driven by regulated services like transport and communications. Luna: So in Germany it's a tight labour market pushing up wages in contact-intensive sectors, and in Italy it's more about regulated tariffs catching up after years of being held down? Lucas: Right. And both are proving very sticky. The ECB's own staff projections show services inflation staying above 3 percent through the end of 2027. That is a problem because services make up about 45 percent of the Eurozone consumption basket. Luna: Which means even if goods inflation goes to zero, the headline is going to stay above target for a while. What does that mean for the rate path? Lucas: It means the doves on the Governing Council who were hoping to cut in September are going to have a much harder time making their case. The hawks — and there are a lot of them — are pointing to services inflation as proof that the last mile is not just slow, it's actually not happening. Luna: Yeah, I saw that Bundesbank President Nagel gave a speech last week where he said, and I'm paraphrasing, 'the battle against inflation is not yet won, and services are the main battlefield.' Lucas: That's exactly the language. And it's not just Nagel. The Dutch, the Austrian, the Finnish governors are all saying similar things. The southern governors — Italy, Spain, Portugal — are more worried about growth and want to ease. So the split is real. Luna: And meanwhile, the euro is at 1.16 against the dollar, which is actually a bit stronger than where it was a few months ago. Does a stronger euro help or hurt here? Lucas: A stronger euro helps slightly on the import side — it makes imported goods cheaper, which puts downward pressure on goods inflation. But for services, which are mostly non-traded, the exchange rate barely matters. So it's not a cure. Luna: Speaking of cures, one thing that always comes up is that services inflation is less sensitive to interest rates because people don't borrow to go to a restaurant or get a haircut. Is that the core of the problem? Lucas: Partly. But there's another layer. A lot of services prices are set by contracts or regulation — think of rents, insurance, public transport. Those adjust slowly, so even if demand falls, prices keep rising for a while. The lag between a rate hike and its impact on services inflation is probably 12 to 18 months longer than for goods. Luna: So the ECB could keep rates where they are for another year and still not see services inflation come down meaningfully? Lucas: That's the risk. And that's why some economists are starting to talk about the possibility that the neutral rate in the Eurozone might actually be higher than pre-pandemic. If services inflation settles at 3 percent instead of 2, then the ECB has to keep rates above that level permanently. Luna: That would be a pretty fundamental shift. For a decade after 2010, the worry was that inflation was too low. Now we might be in a regime where it's structurally higher. Lucas: Yeah, and that has huge implications for everything from bond yields to housing to fiscal policy. But let's zoom in on one specific sector that's really emblematic of this whole story: the German hospitality industry. Luna: Because that's where the labour shortage and wage pass-through are most visible? Lucas: Exactly. Restaurant prices in Germany were up 7.8 percent year-over-year in April. That's nearly double the national average for services. And the reason is simple: the industry lost a lot of workers during COVID who never came back, and then the minimum wage went up significantly. Restaurants have to pay more to attract staff, and they pass that on. Luna: And there's no automation fix for a waiter or a chef. So those price increases are probably permanent. Lucas: Right. And that's not just Germany. In France, café and restaurant inflation is running close to 6 percent. In Spain, it's about 5.5. This is a Eurozone-wide phenomenon driven by a tight labour market, not by any one country's policy mistake. Luna: So if the ECB can't do much about labour shortages, and rate hikes have a limited effect on services, what can they actually do? Lucas: That's the million-euro question. Some argue they need to break the wage-price spiral by engineering a slowdown — basically, raise rates enough to increase unemployment. Others say that's too blunt and the solution is structural: more immigration, more labour market flexibility, more competition in services sectors. Luna: But the ECB doesn't control immigration policy. That's a national competence. Lucas: Exactly. So the ECB is stuck with monetary policy tools that are not well-suited to the problem. And that's why we're seeing this internal division. The hawks want to keep rates high until services inflation breaks. The doves say that would cause unnecessary damage and the inflation will fade on its own as the labour market cools. Luna: Which side do you think is right? Lucas: I think the data supports the hawks in the near term. Services inflation is not showing any meaningful deceleration. The composite PMI services price index is still elevated. But over a 12-month horizon, I think the doves have a point — wage growth is already slowing in some countries, and the lag effects of past rate hikes are still feeding through. Luna: So the next few months are going to be really telling. If services inflation stays above 4.5 percent through the summer, the hawks will have the upper hand at the September meeting. Lucas: Exactly. And if it drops below 4 percent, the doves will start arguing for a cut. Either way, it's going to be a close vote. Luna: You know, listening to you break this down, it really makes you appreciate how much work goes into understanding these dynamics. Lucas: Absolutely. And we're lucky we get to do this every day. If walking through the economy with us has made something click for you, we'd love your support. We deliberately don't run ads on these episodes, and listener contributions are what keep that possible. The link is buy me a coffee dot com slash fexingo. Luna: Yeah, even a small contribution helps us keep the show independent and ad-free. It's a way to say this kind of deep-dive economics content matters. Lucas: Okay, back to the inflation picture. One more data point I want to highlight: the services producer price index, which measures what businesses pay for services like logistics and consulting, rose 5.2 percent year-over-year in April. That suggests margin pressure is still building. Luna: So not just consumer services, but business services too. That could feed into goods prices eventually, as companies pass on higher input costs. Lucas: Right. So we have multiple layers of stickiness. And that's why I think the ECB's next move is likely to be a hold in September, not a cut. They need to see more evidence that services inflation is on a sustained downward path. Luna: And if they hold, what happens to the euro? It's already up this year. A hold could push it higher, which would help a bit on goods inflation but hurt export competitiveness. Lucas: Yeah, the trade-weighted euro has appreciated about 3 percent since January. That's a headwind for German exporters who are already struggling with weak global demand. So there's a trade-off. Luna: There's always a trade-off. That's what makes this job interesting, I guess. Lucas: Indeed. We'll be watching the June inflation print closely. If services shows any sign of cracking, the debate changes. But for now, the ECB is in a waiting game.