Eurozone inflation has climbed again after several months above target, with core inflation unexpectedly rising, boosting the probability of a September rate hike by the European Central Bank to 85%.
The European Union's statistics agency reported on Friday that the eurozone's annual CPI rate rose to 2.9% in July, up from 2.8% in June, aligning with expectations from a Reuters poll. The annual energy price increase accelerated from 8.5% to 10%, serving as the primary driver of this inflation rebound, fueled by surging oil prices from the Middle East conflict.
More notably for markets, the core CPI, which excludes food and energy, unexpectedly climbed from 2.4% to 2.5%, while services inflation edged up from 3.2% to 3.3%. This indicates that price pressures are beginning to penetrate the broader economy. ECB President Christine Lagarde, after holding the key interest rate at 2.25% last week, warned that the spillover effects of the energy shock could be stronger than anticipated and stated that the central bank would remain "highly vigilant" regarding broader price pressures in the coming weeks.
Data from the interest rate swap market shows traders are currently pricing in an approximately 85% probability of a rate hike in September and are betting on one or two additional 25-basis-point increases within the year.
Energy Shock is the Core Driver, Oil Price Trends Become Key Variable
The direct source of this inflation uptick is energy. Driven by the ongoing Middle East conflict pushing up global oil prices, eurozone energy prices rose 10% year-on-year in July, a clear acceleration from June's 8.5% increase. Brent crude oil, after briefly dipping below pre-war levels in late June, has rebounded sharply, gaining over 22% since the start of the month.
Bert Colijn, Chief Economist at ING, pointed out that inflation has "ample upside potential" in the coming months. If oil prices remain at current levels, August's reading will be "significantly higher than July's." Preliminary signs of wage pressures are also emerging, further increasing the risk of persistent inflation.
On the offsetting side, food inflation continued its downward trend this year, falling to 1.2% in July. Non-energy industrial goods price increases remained low at 0.9%, reflecting, to some extent, the relatively cheap prices of imported goods from China. The euro showed little reaction to the data release, falling slightly by 0.1% against the US dollar to $1.152.
July Data Not Decisive, But Has Pushed ECB onto a Rate Hike Track
Although the inflation data exceeded expectations, analysts cited by Reuters believe the July figures alone will not be a "decisive factor" for the ECB's policy. Before the next rate-setting meeting on September 10th, policymakers will also receive the August inflation reading, and the high volatility of oil prices leaves room for uncertainty.
Nevertheless, the overall consensus among markets and analysts is converging. Kamil Kovar, Eurozone Forecasting Director at Moody's Analytics, stated that given developments in the Middle East in July, Friday's inflation data will "firmly set the ECB on a path towards a September rate hike." Neil Birrell, Chief Investment Officer at Premier Miton, commented that to prevent the ECB from acting in September, there would need to be a "major reversal of events and the outlook."
The ECB has previously signaled clearly that the economic trajectory is in line with its "baseline scenario," which itself presupposes a rate hike in September. The second-quarter GDP growth of 0.4%, which significantly exceeded expectations, has also further alleviated concerns that rate hikes might stifle economic growth.
Economic Resilience Eases Rate Hike Concerns, But Divergence Remains on Subsequent Path
The eurozone economy grew by 0.4% quarter-on-quarter in the second quarter, double the forecast. Inflation rates also rose in France, Germany, and Spain simultaneously. Except for Estonia, inflation in all member states is above the ECB's 2% target. This marks the fifth consecutive month that eurozone inflation has exceeded the target, providing a stronger basis for policy tightening.
However, analysts are divided on the pace of subsequent rate hikes. Financial markets have fully priced in two more rate hikes for October and April next year. Economists, on the other hand, generally hold a more cautious stance, with most expecting only one additional rate hike. Their reasoning is that the energy price increase has not yet triggered "second-round effects" on wages and prices, and the relatively weak labor market suggests wage pressures will remain moderate.
Services inflation has been above the ECB's target for over three consecutive years. This structural pressure will be a key metric for the ECB to gauge whether inflation is truly under control and will directly influence its policy direction after September.
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