Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Inflation Divergence Is Forcing Uneven Policy
Transcript
- Lucas: Luna, I want to focus on something that's been hiding in plain sight this spring. Headline inflation across the Eurozone is down, but when you peel back the national numbers, the gap between countries is actually widening — and it's starting to create real tension for ECB policy. Luna: You mean the fact that German inflation is now notably lower than Spanish? That's been creeping up over the past few months. Lucas: Exactly. As of the latest data, German headline CPI is running around 2.1 percent. Spain? 3.8 percent. That's a gap of nearly 170 basis points — the widest it's been since the energy crisis of 2022. And the drivers are very different. Luna: Right. Germany's benefiting from the base effects of last year's energy price declines, plus their wage growth is starting to moderate. Spain is still dealing with the lagged effects of those energy subsidies being withdrawn. Lucas: Exactly. The Spanish government rolled back a lot of the VAT cuts and fuel discounts that had been in place since 2022. That's adding a direct lift to prices. But it's not just fiscal policy — services inflation in Spain is also stickier. Tourism demand is still strong, and that's pushing up hotel and restaurant prices. Luna: And Portugal? I saw their inflation ticked up too, though not as much. Lucas: Portugal is at about 2.8 percent — so in between. But the interesting case is Italy. Italian headline inflation is around 2.4 percent, but core inflation — stripping out energy and food — is still above 3 percent. That's partly because of the phasing out of their own energy support measures. Luna: So the ECB is looking at a Eurozone average of maybe 2.5 percent, but that average masks a split. Does that mean the ECB can't keep raising rates at the same pace for everyone? Lucas: That's the million-euro question. The ECB's mandate is price stability for the whole bloc, not individual countries. But if they keep tightening to cool Spain and Portugal, they risk over-tightening for Germany, where the economy is already soft. German industrial production has been contracting on a year-over-year basis. Luna: And the bond market is already pricing that in, right? I noticed Spanish and Italian bond yields have been compressing relative to German Bunds — the spreads are narrowing. Lucas: Yes. The spread between Spanish 10-year yields and German Bunds has tightened by about 30 basis points since April. That tells you investors think the ECB is nearing the end of its hiking cycle, and they're more comfortable with Southern European debt. The risk premium is shrinking. Luna: But if inflation in Spain stays hot, doesn't that create a problem for the ECB? They can't really cut rates if a major economy is still running above target. Lucas: That's the tension. The ECB's own projections show inflation converging back to 2 percent by late 2026, but that forecast assumes energy prices stay stable and wage growth cools everywhere. If Spanish inflation stays elevated because of domestic demand and services, the ECB might have to keep rates higher for longer — and that would hit Germany harder. Luna: So it's a two-speed recovery within a single currency union. That's exactly the kind of divergence the Eurozone was designed to avoid, but has struggled with since the sovereign debt crisis. Lucas: Right. And it's not just inflation. Look at GDP growth — Spain is forecast to grow around 2.5 percent this year, Germany maybe 0.8 percent. The ECB's one-size-fits-all policy is going to feel more uncomfortable the longer this persists. Luna: You know, walking through these differences with you makes something click — we talk about the Eurozone as a bloc, but the real story is in the national details. And that's exactly why we keep this podcast ad-free. We don't have to simplify for sponsors. If you find this kind of analysis useful, and want to support that independence, you can buy us a coffee — literally. It's at buy me a coffee dot com slash fexingo. And it genuinely helps us keep doing this. Lucas: Yeah, it's a small way to keep the lights on without ads. Appreciate anyone who does. So back to the divergence — the other factor is the labor market. Luna: Because wage growth is still running hot in services in Spain and Italy, while German wage settlements are starting to moderate. Lucas: Exactly. The ECB's latest wage tracker shows negotiated wage growth in Spain running at 4.5 percent year-over-year, versus 3.8 percent in Germany. That feeds directly into services inflation. And since services are less sensitive to interest rates than goods, it's harder to cool down. Luna: So what does this mean for the next ECB meeting? I know the market is pricing a hold, but could they surprise with a hike if Spanish inflation doesn't ease? Lucas: I think a hike is unlikely unless we see a broad acceleration. The ECB's own rhetoric has shifted to 'data-dependent' and 'meeting-by-meeting'. But if the divergence persists, I wonder if they'll start using more targeted tools — like tiering for reserve requirements, or even more aggressive forward guidance that differentiates by region. That would be unprecedented. Luna: And what about the euro? The euro has strengthened against the dollar recently — about 1.16 now, up from 1.15 a week ago. A stronger euro actually helps contain imported inflation, which disproportionately benefits countries that import more energy, like Germany. Lucas: That's a good point. The trade-weighted dollar index has slipped a bit, too — it's at 119.5 from 120.12. So the euro's strength is partly a dollar weakness story. But it does create a headwind for Eurozone exports, especially for Germany, which relies on exports more than Spain or Italy. Luna: So you've got a currency that's strengthening at a time when the bloc's largest economy is already struggling. That's a tough spot for the ECB. Lucas: It is. And it's why I think the market is pricing in rate cuts by early next year. The swaps market is implying about 50 basis points of cuts by June 2027. That might be optimistic if Southern European inflation stays sticky. Luna: But if the ECB cuts too early, they risk re-igniting inflation in Spain and Portugal. If they hold too long, they crush German demand further. There's no clean path. Lucas: No clean path, but there is a precedent. In 2012-2014, we had a similar divergence — core countries like Germany and France had low inflation, while peripheral countries like Greece and Spain had much higher inflation because of structural reforms and VAT hikes. The ECB kept rates low for the core, and the periphery eventually converged. Luna: But that was a different environment — the periphery was in recession then. Now Spain is growing strongly. So the convergence might take longer. Lucas: Exactly. And that's why I'm watching the Spanish and Italian services PMIs closely. If they stay above 55, the ECB will have a hard time justifying cuts. But if they slip, the door opens. Luna: So what's your base case for year-end? Rates unchanged? Lucas: I think one more cut is possible if the German economy weakens further, but it's a close call. The ECB will want to see a few more months of data before moving. The divergence is the key variable — and it's not going away soon. Luna: It's a fascinating moment for the euro experiment. One currency, but increasingly two economies. Lucas: Exactly. And that's the story we'll keep tracking. Thanks for listening.