Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / How Eurozone Services Inflation Is Running Hot in 2026
Transcript
- Lucas: So the ECB just raised rates yesterday for the first time since 2023. And markets are still trying to figure out why, when headline inflation has dropped from its peak. But look closer — services inflation in the Eurozone is running at 4.5 percent year-over-year as of the latest reading. That's the real problem. Luna: Right, because energy and goods prices have come down, but services are still climbing. What's driving that stickiness? Lucas: It's mostly labor costs. Services are labor-intensive — think restaurants, hotels, haircuts, healthcare. And wages in the Eurozone are still growing at around 4 percent annually. That feeds directly into prices because there's no productivity offset. Unlike manufacturing, where automation can absorb some cost increases, services are harder to automate. Luna: So the ECB is essentially fighting a wage-price spiral in the services sector? That's a different beast than the energy shock we saw in 2022. Lucas: Exactly. In 2022, inflation was imported — natural gas prices spiked because of the war. Central banks could raise rates to cool demand, but the source was external. Now, services inflation is domestic. It's about tight labor markets, strong wage negotiations, and consumers who are still spending on experiences. The ECB can't just wait for energy prices to fall. Luna: And this is why they hiked yesterday, even though the macro backdrop is shaky — with the Iran conflict and the UK economy shrinking in April. They must be worried about second-round effects. Lucas: Exactly. The UK shrank 0.1 percent in April, and the Eurozone isn't exactly booming either. But the ECB's mandate is price stability. If they let services inflation entrench, it becomes much harder to break later. Lagarde made that clear in the press conference. Luna: Let's talk about which services are driving this. I've seen data showing that hospitality and recreation are up over 5 percent year-over-year in countries like Spain and Italy. Tourism demand is still strong. Lucas: That's a big part of it. Post-pandemic, Europeans shifted spending from goods to experiences. That demand hasn't faded. And in sectors like hospitality, labor shortages are still acute. Employers have to raise wages to attract staff, and those costs get passed on as higher menu prices. The same dynamic is playing out in healthcare and personal services. Luna: So it's not just a catch-up effect — it's structural? Because if wages keep rising at 4 percent and productivity growth is near zero, services inflation is going to stay above the ECB's 2 percent target for a while. Lucas: That's the fear. And it's why the ECB is willing to risk a recession to get inflation down. They'd rather have a mild downturn now than a prolonged period of above-target inflation that de-anchors expectations. The question is whether higher rates will actually cool services demand. People still want to travel and dine out. Luna: But higher rates do affect business investment and hiring. If companies see borrowing costs rise, they may slow expansion, which could eventually soften the labor market. That's the transmission mechanism. Lucas: Right. And there are early signs that services activity is cooling. The Eurozone services PMI has been edging down. But it's still above 50, so it's expansionary. The ECB needs to see it drop closer to 50 or below to be confident that demand is easing. Luna: One thing I find interesting is the divergence between countries. German services inflation is lower than in Southern Europe. Does that complicate ECB policy? Lucas: It does. The ECB sets one rate for the whole bloc. If Germany is closer to target but Spain and Italy are running hot, a rate hike that's right for the periphery might be too tight for the core. That's always been the challenge of a one-size-fits-all monetary policy. Luna: And yet, they went ahead. So the hawks clearly won the argument. What's your take — will this rate hike be enough? Lucas: I think it's a step, but not a solution. Services inflation is sticky by nature. It responds slowly to interest rates because it's tied to wages and labor market tightness. The ECB might need to hold rates at this level for an extended period, or even hike again if wage growth doesn't moderate. Markets are pricing in another 25 basis points by September. Luna: So we're looking at a higher for longer scenario in Europe, similar to what the Fed signaled in the US. That has implications for bond markets, equities, and the euro. Lucas: Absolutely. The euro has actually strengthened a bit on the rate hike, which helps contain imported inflation but hurts exporters. And European equities have been volatile — the VGK ETF is up 2.7 percent over the last five days, but that's probably more about relief that the ECB is acting decisively, not because the outlook is rosy. Luna: Let's zoom in on one specific sector: air travel. Airlines have been raising prices significantly. Is that mostly fuel costs or labor? Lucas: Both, but increasingly labor. Fuel costs have come down from 2022 highs, but airline staff — pilots, cabin crew, ground handlers — are demanding higher wages after years of stagnation. And there's a shortage of qualified pilots in Europe. That's pushing up ticket prices, which feeds into the travel and tourism component of services inflation. Luna: And that's something consumers feel directly. When you book a summer holiday and it costs 20 percent more than last year, that shapes inflation expectations. Lucas: Exactly. Inflation expectations are the key variable. If consumers and businesses start expecting 3 or 4 percent inflation to be the norm, they'll adjust their behavior — demanding higher wages, raising prices preemptively. The ECB has to break that psychology. That's why they're willing to be aggressive. Luna: So where do we go from here? If you're an investor or just someone trying to plan their finances in Europe, what's the takeaway? Lucas: I think the takeaway is that services inflation is the new front in the inflation fight. It's less visible than energy prices, but more persistent. For investors, that means we're likely in a higher rate environment for longer than many hoped. Bond yields may stay elevated, and growth-sensitive sectors could struggle. For households, it means the cost of services — from dining out to insurance to healthcare — will keep rising faster than the cost of goods. Luna: And for policymakers, it means the labor market is now the central battleground. Wage data will be the most important indicator to watch in the coming months. Lucas: Exactly. The ECB will be poring over every negotiated wage settlement. If wage growth stays above 4 percent, they'll keep hiking. If it starts to moderate, they might pause. But given the tightness in the labor market, I wouldn't bet on a rapid slowdown. Luna: Before we wrap, I want to circle back to something you said about the ECB's willingness to accept a recession. Do you think that's credible? I mean, the Eurozone economy is already fragile. Lucas: I think they're credible in their commitment, but there are limits. If growth really tanks and unemployment starts rising sharply, the political pressure to ease off will intensify. Especially in countries like Italy, where high debt levels make higher rates painful. So there's a balancing act. But for now, inflation is the priority. Luna: Fair point. Alright, last question: do you see any scenario where services inflation comes down without a recession? Lucas: It's possible if productivity improves. If European service companies invest in technology and become more efficient, they could absorb wage increases without raising prices as much. But that's a long-term story, not something that will happen in the next six months. So in the near term, I think we need to accept that services inflation will remain above target, and the ECB will keep rates elevated. Luna: That's a sobering outlook, but it's grounded in the data. And on that note, if today's episode helped you make sense of the ECB's thinking, we'd love it if you considered supporting the show. It keeps us independent and ad-free. Lucas: Yeah, honestly, if walking through the economy with us has made something click, that's the link — buy me a coffee dot com slash fexingo. It's a small gesture that goes a long way. Luna: And we really appreciate it. So back to the data — one last thing I want to highlight: the Eurozone services PMI for May came in at 53.2, down from 54.1. Still in expansion, but the trend is downward. If that continues, the ECB might see the evidence they need that policy is working. Lucas: That's the key indicator to watch. If the PMI drops below 50 in the next few months, the debate shifts from 'how high' to 'how long.' For now, though, the services inflation story remains the dominant theme in European monetary policy. Thanks for listening, and we'll be back tomorrow.