By Tomasz Wieladek, chief European economist at T. Rowe Price
While euro area HICP inflation declined from 2.8% in January to 2.6% in February, this was stronger than analyst expectations. Importantly, Core CPI inflation, the best medium-term predictor of inflation, only declined from 3.3% to 3.1%. This is a significantly stronger reading than the 2.9% expected. While core goods inflation continues to be weak, worryingly, momentum in seasonally adjusted services inflation rose to 0.51% – assuming similar seasonality to last year. Regardless of perspective, this is clearly a strong services inflation print and much stronger than expected.
The ECB is concerned about persistence in domestically generated inflation. Euro area services inflation is the best proxy for domestically generated inflation. This is clearly too strong. Forward-looking indicators suggest that services inflation may stay at these highly elevated levels for a long time. Within business surveys, whether the PMI or the European Commission, services price indices rose for a fourth month in a row and are clearly at levels significantly above those required to reach the inflation target. Wage pressure, a key driver of services inflation, remains too strong. The ECB’s negotiated wage indicator rose to 4.5%. The only hope to reduce the pass-through of these higher costs into services price inflation was via lower profit margins. But this required weak services demand. However, the latest service PMI suggests that eurozone service activity is not contracting anymore, which means this channel of adjustment will likely be weaker than expected. Overall, the data today shows services inflation is running at a too-high rate and will likely stay at these elevated levels.
These data tie the hands of the ECB, which will need to keep monetary policy tighter for longer to squeeze the services inflation persistence out of the economy. This means the ECB may need to delay the first cut beyond June. When it does eventually cut, it will likely cut gradually, perhaps once a quarter, rather than at every meeting. It also cannot be ruled out that the ECB may eventually need to hike again if the data continue to indicate rising and persistent services HICP inflation.
