As rising energy prices spread and trigger broader inflationary pressures, the European Central Bank is expected to implement its first interest rate hike in nearly three years this Thursday. However, economists note that current signs of second-round price effects remain limited.
Inflation in the Eurozone accelerated to 3.2% in May, while the core inflation rate, which excludes volatile energy and food prices, unexpectedly rose to 2.5%. This suggests that the shock of high oil prices stemming from the Middle East conflict is beginning to spread beyond the energy market.
Vincent Stamer, a senior economist at Commerzbank, stated, "The rise in core inflation to 2.5%, driven particularly by services, is somewhat surprising." He added that this fuels concerns that higher energy costs have started to feed into the prices of other goods and services.
Service sector inflation rose to 3.5% in May from 3.0% in April. Concurrently, recent surveys indicate that manufacturers' input costs are rising at their fastest pace since May 2022, and the final prices these manufacturers charge their customers are also increasing at the quickest rate in three and a half years.
Alongside the anticipated rate hike on Thursday, the ECB is also expected to revise upwards the inflation forecasts it made in March, which were based on the assumption of a swift end to the conflict involving Iran.
Claus Vistesen, Chief Eurozone Economist at Pantheon Macroeconomics, commented, "They will essentially acknowledge that inflation next year will also be significantly above 2%." He added that the ECB might incorporate some second-round effects into its projections.
However, so far, the impact of high energy costs has not manifested in higher wage demands, which is the scenario central bank officials fear most.
Following the onset of the Russia-Ukraine conflict in 2022, wage increases followed closely behind soaring energy prices, creating a cycle of rising prices and wages. Although the ECB initially predicted this was a temporary price shock, the wage-price spiral pushed inflation above 10%.
Preventing a recurrence of such a wage-price spiral is currently the ECB's top priority. As of now, this danger has not materialized.
"I would avoid using the term 'spiral'," said Stamer of Commerzbank. "It is entirely possible that the indirect effects are transmitted only once and then gradually fade away."
Currently, the transport sector appears to be the area where the pass-through effect of energy prices is most evident. Consequently, many economists expect core inflation to continue rising modestly throughout the second half of the year. This further reinforces expectations that the ECB will hike rates this week and potentially again in July, despite a general slowdown in wage growth across the Eurozone.
Vistesen remarked, "They would rather risk hiking now and having to cut later than sit back and watch inflation get out of control."
The challenge facing the ECB is balancing inflation risks against an economy that appears significantly weaker than in 2022. The current labor market seems softer, with a substantial reduction in job vacancies.
To many economists, workers appear to be in a weaker bargaining position. Some even see a risk that as falling household purchasing power dampens demand, high energy prices could adjust, potentially ultimately exerting downward pressure on inflation.
Nevertheless, policymakers are not yet out of the woods, with more significant price movements potentially ahead.
Currently relatively moderate food price inflation could become the next major concern. Stamer noted that historically, it can take up to 12 months for increases in oil and fertilizer prices to fully pass through the food supply chain, meaning much of the impact is not yet visible in consumer prices.
Pantheon Macroeconomics forecasts food inflation will climb to between 4% and 5% next year, compared to 2.2% in April. Disruptions in the Strait of Hormuz have reduced the supply of chemicals needed for fertilizer production, but the impact of rising farmer costs on food prices will depend on inventories and planting cycles.
These factors will largely depend on how long the Middle East conflict persists. The longer energy supply disruptions continue, the greater the risk of broader inflationary effects. While economists still do not expect a wage-price spiral like 2022, this shock has already raised the floor for core inflation, increasing the likelihood that price increases will remain above the ECB's 2% target for longer than policymakers anticipated.
Vistesen concluded, "Even if the US and Iran reach an agreement tomorrow, I don't think you can escape this reality."
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