Written by Katharine Neiss, chief European economist at PGIM Fixed Income
The market is increasingly of the view the European Central Bank (ECB) will raise its policy rate by an unprecedented 75bps at its next meeting. This is on the back of further upside surprises in headline inflation data, as well as surging European wholesale energy prices.
That said, it is not clear such a punchy move is warranted. Negotiated wage growth fell back in Q2 2022, and remains below levels consistent with a 2% inflation target. Moreover, the near-term trend in services inflation, which may offer a better read on domestic inflationary pressure, has fallen back and is now consistent with the ECB’s 2% inflation target.
However, higher-for-longer inflation risks becoming embedded in the economy, making the painful adjustment to the energy shock much harder. The ECB will be very anxious to avoid aggravating an already difficult situation for the region.
It is worth highlighting the futility of using monetary policy to bring inflation to 2% when energy prices are being pushed up by war. As an illustration, if energy prices faced by consumers rise by 50%, then all other prices would need to fall by roughly 5% to keep average inflation at 2%. Historically, such a large reduction in prices could only be achieved via a severe contraction in economic activity and rise in unemployment. It is not clear such an outcome would achieve ‘price stability’. For the shocks facing the euro area, it seems there are no easy answers.