By Balazs Koranyi and Maria Martinez
FRANKFURT, March 31 (Reuters) – Euro zone inflation soared past the European Central Bank’s 2% target this month as surging oil and gas costs drove up headline prices, but the jump was smaller than expected and core inflation declined, muddying the picture for policymakers.
Overall inflation in the 21 countries sharing the euro currency jumped to 2.5% in March from 1.9% a month earlier, below expectations for 2.6% in a Reuters poll of economists, as energy costs rose 4.9%.
Oil prices have nearly doubled as a result of the Iran war and the ECB is now debating whether to raise interest rates to prevent this surge from becoming entrenched in the price of other goods and services.
“The previously price-stable environment is saying goodbye” said Alexander Krueger, chief economist at Hauck Aufhaeuser Lampe. “What matters is that this inflationary dirt does not feed through into the core rate.”
A closely-watched figure on underlying inflation, which excludes volatile food and energy, meanwhile, fell to 2.3% from 2.4%, data from Eurostat, the EU’s statistics agency showed on Tuesday.
“Looking ahead, although this was the biggest monthly increase in headline inflation since late 2022 it tells us little about how far headline inflation will rise or how much it will feed through to core and services inflation,” said Andrew Kenningham, chief Europe economist at Capital Economics.
HIKE OR LOOK PAST?
Basic economic theory argues that central banks should look past one-off price shocks generated by supply disruptions, especially because monetary policy works with long lags.
But a quick rise in energy inflation can easily broaden out if companies start building this into selling prices and workers begin demanding higher wages for the loss of disposable income.
Germany’s leading economic institutes cut their growth forecasts for this year and next in Europe’s biggest economy, while sharply raising their inflation forecasts in response to the Iran conflict, underscoring the drag the conflict is expected to exert on the economy.
High energy prices should make other goods more expensive and push up core inflation, said Commerzbank’s chief economist Joerg Kraemer, forecasting headline inflation will rise above 3% by May unless the war ends quickly.
The public may also start doubting the ECB’s resolve if it remains idle, firming the case for rate hikes even in the event of large but not so persistent inflation episodes, ECB President Christine Lagarde said last week.
Financial markets now see three interest-rate hikes from the ECB this year, with the first in either April or June.
“The mounting inflation pressure suggests that the ECB will raise its key interest rates in April or, at the latest, in June,” Kraemer said.
While some policymakers such as the influential Bundesbank head Joachim Nagel said a rate hike as soon as April was an option, others, including ECB board member Isabel Schnabel, have warned against hasty action.
But policymakers agree that the ECB must act if energy starts generating second round price pressures, especially since domestic inflation had been above 2% for years.
“The risk of a policy mistake is now substantial on either side of the incoming stagflation shock,” said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics.
If governments cushion the blow from higher prices with tax cuts, subsidies or cash handouts, central banks may have to tighten policy more aggressively, but if they leave households to absorb the shock, economic growth could weaken sharply and eventually force rate cuts, Vistesen said.
Services inflation, the single largest item in the consumer price basket and the key gauge for domestic inflation, fell to 3.2% in March from 3.4% a month earlier.
Part of the issue is that the ECB was late in recognising the inflation problem in 2021/22, arguing for months that the surge was transitory and would pass. It only raised rates when price growth hit 8%, forcing the central bank into its steepest tightening cycle in its history.
“Consumers expect another rough ride, the past shock still fresh in memory,” said Bert Colijn, chief economist for the Netherlands at ING, adding that inflation expectations just increased to levels seen in the early 1990s and during the first half of 2022.
But the bloc is now in a very different position, so comparisons with 2022 are not entirely valid.
Rates are already higher, budget policy is tighter, the labour market has been weakening for months and there is no pent-up demand created by pandemic-era lockdowns.
The ECB will next meet on April 30.
“We find it hard to see the ECB moving at the next meeting at the end of April,” said Carsten Brzeski, global head of macro at ING. “Unless the ghosts of 2022 are really keeping policymakers awake at night.”
(Reporting by Balazs Koranyi and Maria Martinez; Editing by Alexander Smith and Arun Koyyur)
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