The inflation rate is falling – “but the pressure on the ECB to act is increased”

It's the perfect timing: Just one day before the interest rate meeting of the European Central Bank (ECB), the statistics office Eurostat presented the latest figures for inflation in the euro area. These show what was widely hoped for: inflation in the euro area is slowing down. And even more clearly than expected.

The data from Luxembourg on Thursday should fuel the interest rate debate in the ECB Council accordingly. There has long been a discussion about how long the central bank intends to stick to its current cycle of tightening key interest rates.

For businesses and consumers who have been suffering from far too high inflation for months, the latest price data is raising hopes that inflationary pressures may ease this year. Consumer prices rose 8.5 percent in January, slower than analysts had expected. They had expected growth of 9.0 percent.

It is the third consecutive month of falling inflation since the high of 10.7 percent last October: In November, the euro economy groaned under an inflation rate of 10.1 percent, in December the rate was nine percent and is now in January even fell below the nine percent mark compared to the previous year.

Nevertheless, economists warn against misinterpreting the decline in headline inflation as the all-clear. “First, inflation is way too high by any measure. Secondly, the core rates, i.e. inflation excluding energy prices and food, continue to rise,” said Jens-Oliver Niklasch from LBBW. "We'll have to keep an eye on that in the coming months. The energy price increase of the previous year is now rolling through all sorts of other product groups and is thus keeping the inflation rate high for the time being.”

In fact, inflation is still far from the ECB's actual two percent target. If one deducts the highly volatile prices for energy and food, it also becomes apparent that the so-called core inflation, which is considered an important indicator of medium-term price developments, is unchanged at a record high 5.2 percent.

“The core inflation rate is likely to remain stubbornly high in 2023. This is due to improved economic prospects, the tight labor market, high wage demands and a high proportion of European companies that expect sales prices to continue to rise,” states Fritzi Köhler-Geib, chief economist at the state development bank KfW. Further rate hikes by the ECB are therefore essential due to persistently high core inflation.

The ECB is expected to hike interest rates by another 50 basis points at its interest rate meeting on Thursday. The US Federal Reserve, which had started the fight against inflation much faster and more aggressively than the ECB last year, had raised US key interest rates by just 25 basis points on Wednesday evening. From the markets' point of view, what is even more decisive is how the monetary watchdogs position themselves with a view to the further course of the interest rate cycle.

At the most recent ECB press conference in December, ECB President Christine Lagarde announced further interest rate hikes beyond the February date in an unusually clear manner. And the so-called interest rate hawks in the Council, who stand for a strict monetary policy course, have long been calling for further increases. For example, the head of the Dutch central bank, Klaas Knot, and Bundesbank President Joachim Nagel.

But this opinion is by no means shared by the entire Council. ECB Director Fabio Panetta, for example, has recently sounded much more evasive and, in a recent interview with the Handelsblatt, advocated that the ECB should initially keep further steps beyond February open.

Most ECB observers agree that the January inflation data should be treated with caution. This applies above all to energy prices, which, at 17.2 percent, did not rise as much as in December, when the prices for oil, gas and fuel rose by 25.5 percent.

However, the effect of state intervention, for example in the form of electricity and gas price brakes in some euro countries, also made itself felt here. On the other hand, the prices of food, alcohol and tobacco at the beginning of the year in the euro area increased by 14.1 percent more than in December.

In addition, the current data in particular is subject to some imponderables, because precisely for Germany, the largest euro economy, Eurostat was only able to fall back on estimated values ​​due to a software problem in the German statistical authorities.

In view of the volatile macroeconomic situation, however, this procedure harbors a great deal of uncertainty. Economists like Ralfcircul from Helaba are therefore preparing for an “unusually high need for revision”.

In fact, the aggregated Eurostat data suggests that there may even have been a slight fall in inflation in Germany in January. According to preliminary data, inflation in other large euro countries such as France and Spain has recently accelerated again: In France, for example, inflation rose to 7.0 percent in January after 6.7 percent in December.

In Spain, the rate climbed from 5.5 to 5.8 percent. However, there was a noticeable decline in Italy, where the inflation rate fell from 12.3 percent to 10.9 percent. Eurostat did not disclose which estimated values ​​for Germany were included in the calculation.

From the point of view of Commerzbank chief economist Jörg Krämer, there is no way around further ECB interest rate hikes anyway. “There is still no all-clear for the ECB. It should continue to raise its key interest rates quickly,” he commented on the current data and the future outlook.

The Munich Ifo Institute also expects further increases. “Inflation has spilled over from energy and food to many other commodities over the course of 2022, gaining breadth. There is a risk that inflation will solidify, which increases the pressure on the ECB to act,” said Ifo expert Sascha Möhrle.

Although a slower price increase is expected for 2023, core inflation will remain high in Germany and other euro countries. "We are assuming that interest rates will rise to four percent by the summer," says Möhrle. The deposit rate for banks at the ECB is currently 2.0 percent.

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