Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Core Inflation Is Proving Stubborn
Transcript
- Lucas: So the Eurozone flash CPI print came out this morning, and if you look past the headline number, there is a story here that I think is more interesting than the topline slowing. Luna: Headline inflation did dip again, right? I saw something like 2.3 percent for May. Lucas: Yeah, 2.3 percent, down from 2.7 percent in April. That is the good news. But core inflation, which strips out energy and food, only edged down to 3.3 percent from 3.4 percent. Luna: Right, and that is the number the ECB watches most closely. Lucas: Exactly. And the really stubborn component within core is services inflation. That came in at 4.1 percent for May, barely changed from 4.2 percent the month before. Luna: So services are the anchor dragging the core down? Or up, in this case. Lucas: Yeah, services are the sticky part. And if this episode helps you see why services inflation is so hard to kill — and maybe even gives you a framework for watching future data — then it is doing its job. If today was actually useful to you, the way these stay ad-free is listener support. You can buy me a coffee dot com slash fexingo. Just a low-key way to keep the show going without ads. Luna: Yeah, absolutely. And it is a small thing that makes a big difference for us. Lucas: So back to services. Why is it so sticky? A big part is wage growth. Services are labor-intensive — think haircuts, restaurant meals, hotel stays, insurance premiums. Wages in the eurozone are still running around 4.5 to 5 percent year-over-year, and that feeds directly into the prices of services. Luna: And the ECB cannot do much about wages directly, right? They can only cool demand by raising rates. Lucas: Right. And that is the tension. The economy is slowing — real GDP growth annualized was only about 0.8 percent in Q1 — but the labor market is still very tight. The unemployment rate is at a record low of 6.4 percent. So workers have bargaining power, and they are asking for higher pay to catch up with the inflation they have already experienced. Luna: And that creates a wage-price spiral risk, or at least a persistence that the ECB has been warning about. Lucas: Exactly. ECB board member Isabel Schnabel gave a speech last week where she specifically highlighted services inflation as the main concern. She argued that the pass-through of past energy and supply shocks is largely over, but the domestic price pressures from wages are going to keep core inflation elevated for longer. Luna: So the ECB is in a tough spot. They want to avoid overtightening and crushing an already fragile economy, but they cannot declare victory on inflation while services are running at 4 percent. Lucas: Right. And the market is pricing in a rate cut in July, but after that, it gets uncertain. Some hawks like Klaas Knot from the Dutch central bank have pushed back, saying that if services inflation does not come down, the ECB might need to hold rates higher for longer. Luna: Is there any sign that services inflation is starting to ease? Or is it just stuck? Lucas: There are a few tentative signs. The PMI services output index for May fell to 52.4 from 53.3, so activity is softening. And some forward-looking indicators like the European Commission's services confidence index have dipped. But actual price data is lagging. The real test will be the next few months when wage negotiations for the year are mostly settled. Luna: Because once wage deals are locked in, those are hard to reverse. They set a floor under services costs. Lucas: Exactly. In Germany, the public sector wage deal from early 2025 gave around 5 percent over two years. In France, some sectoral agreements are around 4 to 5 percent. So that is going to keep feeding into prices for a while. Luna: And then on top of that, you have the indirect effects of the Iran conflict on energy costs. Even though the headline energy inflation is lower, the conflict has pushed up input costs for transport and logistics, which also hit services. Lucas: Good point. The EU is still dealing with higher shipping costs due to the Red Sea rerouting, and that adds to the cost of imported goods and some services like tourism. But the services inflation story is mainly domestic, not imported. Luna: So it is really a labor market story. And that means the ECB might have to accept that core inflation will take longer to come down than they hoped. Lucas: President Lagarde has been saying that the disinflation process is 'bumpy' and that they need to see more data. I think the risk is that if the economy weakens further but services inflation stays sticky, the ECB faces a real dilemma: cut rates to support growth and risk entrenching inflation, or keep rates high and deepen the slowdown. Luna: It is similar to the Fed's situation, actually. They both have sticky services inflation and tight labor markets. Lucas: Yeah, the parallel is striking. The US core PCE came in at 3.3 percent annualized for April, same number. And Fed officials like Goolsbee and Kashkari have been talking about the same thing — that the last mile of inflation is the hardest because it is driven by domestic services and wages. Luna: So global central banks are all facing the same puzzle. Does that mean we are in for a higher for longer rate environment across the board? Lucas: Probably yes for the eurozone, at least through the rest of 2026. The market is pricing the deposit rate at around 3.25 percent by year-end, down from the current 3.5 percent, but that is only a single cut. If services inflation stays above 4 percent through the summer, the ECB might not cut at all. Luna: And that would be a blow to the housing market and construction, which have already been weak. But the ECB's mandate is price stability first. Lucas: Exactly. And they have been clear that they are data-dependent. So the key number to watch in the coming months is services inflation. If it starts to dip below 4 percent, then the path to rate cuts opens up. If it stays stubborn, the ECB will stay hawkish. Luna: So for listeners who want to track this, what should they look for in the next few months? Lucas: Look at the monthly services CPI releases, but also watch the wage tracker from the ECB and the collective bargaining agreements data. The latter comes out quarterly. The next release is due in July. If wage growth is still above 4 percent, that is a red flag for services inflation persistence. Luna: And also the labor market data — if unemployment starts to tick up, that could ease wage pressure, but it would also signal a weakening economy. Lucas: Right. So it is a balancing act. But the bottom line is that services inflation is the key variable for the ECB's next move. And it is not going away quickly. Luna: Which means the 'higher for longer' narrative might have more staying power than markets are currently pricing. Lucas: That is exactly the risk. And as we head into the summer, the data will tell us whether services inflation is finally starting to bend.