Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Services Inflation Is Sticking Around
Transcript
- Lucas: The ECB has cut rates three times so far this year. But services inflation across the Eurozone is still running above 4 percent. And not just in the usual suspects like Spain or Portugal — Germany's services inflation is at 4.2 percent, France at 3.9. The central bank's own projection from December assumed it would be below 3 by now. Luna: So what's keeping it so sticky? I mean, energy prices have come down from their 2022 peaks, supply chains are normalised — you'd think the services sector would cool too. Lucas: That's the puzzle. And a big part of the answer is that services inflation is much more domestic and much more linked to labour costs than goods inflation. Take the latest composite PMI for May — services input costs accelerated to a 10-month high. That's wages, that's rent, that's energy costs that hotels and restaurants can't absorb anymore. Luna: And energy is actually still a factor indirectly, right? Because the Iran conflict has kept oil and gas prices elevated. Even if households see lower bills than 2022, businesses haven't fully passed through the earlier spikes. Lucas: Exactly. The ECB's Christine Lagarde said last week that the 'last mile' of disinflation is proving the hardest precisely because it's now about domestic price-setting behaviour, not global supply shocks. And wages in the Eurozone grew by 4.7 percent year-over-year in Q1 — that's above productivity growth, so it feeds into unit labour costs. Luna: But isn't some of that wage growth just catch-up after real wages fell dramatically in 2022 and 2023? Workers are trying to regain lost purchasing power. Lucas: Absolutely. And the ECB acknowledges that these are 'catch-up' effects. The problem is the timing and the persistence. When you have tight labour markets — unemployment at 6.3 percent across the bloc — workers have more bargaining power. That keeps wage pressure going even after the catch-up phase should have faded. Luna: And then there's the tourism effect. I was looking at data from Spain — tourism arrivals in April were up 15 percent year-over-year. That pushes up hotel prices, restaurant prices, even local services like transport. It's a small country dynamic that ends up affecting the Eurozone average. Lucas: Spain's services inflation is running at 5.1 percent. Portugal at 4.9. Greece at 4.7. Those three together have enough weight in the Eurozone HICP to nudge the whole index higher. And it's not just Southern Europe — Ireland is at 4.3 percent, driven by services. Luna: So what can the ECB actually do? They've already signalled they might pause the cutting cycle after the June meeting. But if they pause, they risk slowing the economy — and the Eurozone economy is already fragile, especially in manufacturing. Lucas: Right. Manufacturing PMI has been below 50 for 18 months now. So the ECB is facing a classic sectoral divergence — goods and manufacturing are weak, but services are still inflation-hot. And raising rates won't fix a tourism boom in Spain or a wage catch-up in Germany. Those are structural, not monetary. Luna: It feels like the ECB is stuck. They can't cut rates aggressively without risking that services inflation becomes entrenched. But they can't keep rates high without hurting the parts of the economy that are already struggling. Lucas: That's the bind. And the data this week didn't help. The Fed's preferred inflation gauge — core PCE — came in at 3.3 percent, exactly as expected. But energy inflation has been more persistent than the Fed expected, and the same is true for the ECB. The Iran conflict is adding roughly 10 to 15 dollars per barrel to oil prices compared to a no-war scenario. That seeps into transport, airfares, logistics — all services inputs. Luna: So a geopolitical shock is essentially prolonging the services inflation cycle. And the ECB can't do anything about that either. Lucas: Exactly. So the question becomes: how much of this services inflation is cyclical and how much is structural? If it's mostly wage catch-up and tourism normalization, it should fade over the next 6 to 12 months. But if it's becoming embedded in expectations — if businesses start assuming 4 percent annual price increases as normal — then the ECB has a real problem. Luna: And the longer it stays above 4 percent, the more likely it becomes embedded. That's the risk. One thing I've been watching is the ECB's own survey of consumer expectations — inflation expectations for 12 months ahead have drifted up to 3.1 percent from 2.8 percent three months ago. Lucas: That's exactly the kind of de-anchoring they worry about. If consumers expect 3 percent inflation a year from now, they'll demand 3 percent wage increases, businesses will price for it, and you get a self-fulfilling spiral. The ECB's credibility is on the line here. Luna: And that's why even the doves on the Governing Council are reluctant to cut again in June. Isabel Schnabel gave a speech last week where she said 'patience is warranted' and that the last phase of disinflation is the most delicate. Lucas: Right. So the base case for June is a hold. Maybe a cut in September if services inflation shows clear signs of easing. But the market is pricing only one more cut this year after the three we've already had. Compare that to the US where the Fed hasn't cut at all — the divergence is stark. Luna: We should talk about what this means for the euro. It's been relatively stable against the dollar around 1.16, but if the ECB pauses while other central banks keep cutting — like the Bank of England or the Riksbank — that could put downward pressure on the euro. Lucas: And a weaker euro would actually add to imported inflation, which is the last thing the ECB wants right now. So they're in a lose-lose on the currency front. A stronger euro would help disinflation but hurt exports. A weaker euro helps exports but adds to inflation. Luna: So what's the one data point you'd watch over the next month to gauge whether services inflation is really easing? Lucas: I'd watch the ECB's negotiated wage tracker. That comes out quarterly, and the Q2 data will be available in July. If wage growth is still above 4.5 percent, then services inflation is unlikely to fall below 3.5 percent by year end. If it drops to 4 percent or below, the ECB might have room to cut again in September. Luna: And the PMI services output prices index — that's monthly and tends to lead the official data by a few months. If that starts to fall below 55, it would be a good sign. Lucas: Good point. It's at 57.4 now, which is still high but down from 58.1 in April. A trend in the right direction. But we need a few more months of data to be confident. Luna: So it's a waiting game. And in the meantime, households in the Eurozone are still feeling the pinch from services costs — dining out, holidays, insurance, haircuts — all the things you can't easily avoid. Lucas: That's the real cost of persistent services inflation. It's not just a number in a central bank report — it's the price of a hotel room in Barcelona being 20 percent higher than last year, or your car insurance premium going up 15 percent. And those are the kinds of prices people notice every day. Luna: Speaking of noticing — one thing we've noticed is that a lot of you listen to this show regularly, and we don't run ads. That's a choice. We keep it ad-free because we think the conversation works better without interruptions. Lucas: Yeah, and that only works because a small group of listeners chips in through buy me a coffee dot com slash fexingo. It's not a big ask — it's just what keeps the economics of the show workable. So if walking through the economy with us has made something click, that's the place. Luna: And we really mean it — no pressure ever. But if you do, it helps us keep doing deep dives like this one on services inflation. So, back to the data — Lucas, you mentioned the wage tracker. When exactly does the Q2 data come out? Lucas: The ECB publishes it in mid-July. And that'll be a key input for the July policy meeting — even though the decision in June will already be made. I think the Council will want to see that number before committing to further cuts. Luna: Alright, so we'll keep an eye on the PMI services output prices in the coming weeks, and then the wage tracker in July. Thanks for the clear breakdown. Lucas: Thanks, Luna. And to our listeners — stay curious. We'll be back tomorrow with another angle on the European economy.