Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Inflation Is Still Sticky at 3.2 Percent
Transcript
- Lucas: So eurozone inflation hit 3.2% in May, and that headline number is getting a lot of attention because it's the first real uptick in months. Luna: And the Iran war is obviously the big driver there — energy costs keep climbing. Lucas: Right. The energy component alone added almost a full percentage point to the headline. But what's more interesting to me is what's happening underneath. Core inflation — stripping out energy and food — came in at 3.3%, basically flat versus April. And services inflation, which the ECB watches most closely, is still above 4%. Luna: So the underlying pressure isn't going away, even if the headline bump is mostly energy. Lucas: Exactly. And that's the tricky part for the ECB. They can't really target energy prices directly — those are external shocks. But services inflation is domestic, driven by wages and demand. And it's proving very sticky. Luna: I saw a note from one of the big research shops calling it a 'double scar' — consumers still bruised from the 2022-2023 inflation spike, and now another wave of price increases from the war. They argued it's changing how people negotiate wages. Lucas: That's a really good framing. The 'double scar' idea suggests that households and unions are now building higher inflation expectations into wage demands preemptively. So even if energy prices stabilize, you've got a wage-price spiral dynamic that keeps services inflation elevated. Luna: And that's exactly what the ECB is worried about — that inflation becomes entrenched in expectations. Lucas: Right. And here's a number that ties in: US job openings surged to 7.6 million in April, the highest in nearly two years. That's a tight labor market. And while Europe's labor market isn't as hot, the trend is similar — low unemployment, plenty of vacancies, upward pressure on wages. Luna: So the ECB could end up having to keep rates higher for longer, even if the economy is sluggish. Lucas: That's the tension. If you look at the growth data, real GDP in the eurozone grew at an annualized rate of 1.6% in Q1, which is actually decent. But that masks a huge divergence. Southern Europe — Spain, Italy, Portugal — is doing well. Germany is barely growing. Luna: And Germany's manufacturing sector is getting hit hard by higher energy costs from the war. Lucas: Exactly. So the ECB has to set one policy rate for a bloc where some countries are growing above trend and others are stagnating. That's always been the challenge, but the energy shock makes it sharper. Luna: Which brings us back to the inflation number. If the ECB cuts rates too soon and services inflation stays above 4%, they lose credibility. If they hold too long, they choke off the recovery in places like Spain. Lucas: And the market is pricing in one more rate cut this year, maybe two. But after today's inflation print, I think that's in doubt. Luna: Yeah, I saw the swap markets shifted — probability of a July cut dropped a bit. Lucas: So where does that leave us? The ECB is stuck between a supply shock and sticky domestic inflation. They need to see services inflation come down meaningfully before they can ease. And the Iran energy premium isn't helping. Luna: If walking through the economy with us has made something click — or even just made your commute a little more interesting — honestly, if today was worth a coffee to you, that's the link: buy me a coffee dot com slash fexingo. Lucas: It really does help keep the show going, and it means we don't have to run ads. So if you're inclined, that's the place. And we appreciate it. Luna: So back to that services inflation — what are the specific categories that are still rising fastest? Lucas: Good question. The big ones are rents and hospitality. Rents are up around 4% year-over-year across the eurozone, and that's partly a supply issue — not enough housing construction in cities like Madrid, Lisbon, Berlin. Hospitality — hotels, restaurants — that's running close to 5%, driven by both labor costs and demand. Luna: So those are the categories that are hardest for the ECB to influence with interest rates. Lucas: Exactly. Rate hikes can cool demand, but they don't build more apartments or train more waitstaff. That's structural. And that's why the ECB's job is so difficult right now. Luna: Let's talk about the consumer side. The 'double scar' idea — how is it actually showing up in behavior? Lucas: There's some really interesting survey data out of the European Commission. Consumer confidence has been bouncing back, but it's still below pre-pandemic levels. And when you ask people about their inflation expectations for the next 12 months, they're still elevated — around 3.5%. Luna: So people expect inflation to stay above the ECB's 2% target. Lucas: Right. And that's dangerous because if consumers expect higher inflation, they change their behavior. They demand higher wages, they accelerate purchases, and that becomes a self-fulfilling prophecy. Luna: I also read that savings rates are staying higher than normal. People are still cautious. Lucas: That's the flip side. The 'scar' from 2022 made a lot of households build a buffer. So you have this paradox: people expect high inflation, but they're also saving more. That actually dampens demand, which should help bring inflation down. But it also means the recovery is uneven. Luna: So what does the ECB need to see to feel confident about cutting rates again? Lucas: They need to see services inflation drop below 3.5% for a few months in a row. And they need wage growth to moderate — especially in the big economies like Germany and France. The most recent wage agreements in Germany were around 5% to 6%, which is still too high for the ECB's comfort. Luna: And with the energy shock from the Iran war, there's a risk that we get another leg of inflation if oil prices spike again. Lucas: That's the wildcard. The conflict has already added about 15% to European natural gas prices since the start of the year. If it escalates further, the ECB could be looking at a scenario where headline inflation goes back above 4% later this year. Luna: So the path forward really depends on geopolitics as much as on the economy. Lucas: It always does, but right now it feels more acute. The ECB's next meeting is in July, and they'll have another inflation print before then. My guess is they hold steady and wait for more data. Luna: That seems prudent. Better to wait and be sure than to cut and have to reverse. Lucas: Exactly. And that's the lesson from the 1970s — premature easing just leads to a second wave. The ECB is acutely aware of that history.