Eurozone inflation climbed more than expected in September, increasing pressure on the European Central Bank to keep interest rates high or consider further hikes.
Rising energy prices remain the main driver of inflation. Higher fuel and natural gas costs could also push consumer prices even higher in the coming months.
Eurozone Inflation Beats Expectations
Inflation across the 21 countries using the euro rose to 3.8% in September, up from 3.2% in August.
The increase was stronger than expected. Economists surveyed by Reuters had forecast inflation of around 3.6%.
Fuel and natural gas prices were the biggest contributors to the increase. Food prices also added to inflationary pressure, although to a smaller extent.
Core Inflation Also Moves Higher
Core inflation, which excludes volatile food and energy prices, increased to 2.5% from 2.4%.
The rise was mainly driven by higher prices in the services sector, according to data from Eurostat, the European Union’s statistics agency.
Core inflation is closely monitored by the ECB because it can provide a clearer picture of underlying price pressures in the economy.
Rising Energy Costs Put Pressure on Governments
Higher fuel and energy prices are also creating political and economic challenges for European governments.
Several governments are facing increasing pressure to support households and businesses struggling with higher energy bills.
In countries such as France, rising costs have already contributed to public protests. Additional support measures could also place further pressure on government finances.
So far, energy subsidies across the eurozone have remained relatively limited, amounting to roughly 0.1% of the bloc’s GDP.
However, some economists argue that these measures are less targeted and less temporary than originally expected. As a result, governments could face longer-lasting budget pressures.
ECB Faces a Difficult Inflation Decision
For the European Central Bank, the latest inflation figures provide mixed signals.
Headline inflation has moved further above the ECB’s 2% target. This could strengthen arguments from policymakers who believe additional interest rate hikes may be necessary.
At the same time, the relatively small increase in core inflation suggests that higher energy prices have not yet caused widespread secondary inflation effects.
Such second-round effects could occur if businesses pass higher energy costs on to consumers or if workers demand much larger wage increases to compensate for inflation.
Could the ECB Maintain Its Measured Approach?
The relatively stable core inflation reading could allow the ECB to continue with what policymakers have described as a “measured” policy response.
Markets generally interpret this approach as meaning interest rate increases could remain gradual and spaced apart.
The ECB could also choose to make major policy changes around the release of its quarterly economic forecasts.
Jack Allen-Reynolds of Capital Economics said September’s inflation figures did not significantly change his expectation that the ECB would wait until December before raising rates again.
However, he added that another sharp rise in energy prices could make an earlier rate increase more likely.
Markets Expect Additional ECB Rate Hikes
Investors currently expect the ECB may deliver several additional interest rate increases over the coming year.
However, expectations can change quickly as new inflation, employment and economic data become available.
ECB officials have also acknowledged that forecasting the inflation outlook remains unusually difficult.
Policymakers who support tighter monetary policy argue that energy costs have remained elevated for long enough to eventually spread into other areas of the economy.
The recent rise in natural gas prices could increase electricity, heating and business costs. Companies could then pass some of those additional expenses on to consumers.
Labour Market Could Limit Inflation Pressure
Other economists see reasons for the ECB to remain cautious.
A relatively weak labour market could limit workers’ ability to negotiate large wage increases. This could reduce the risk of a wage-price spiral.
Higher borrowing costs may also slow economic activity and reduce inflation over time.
Interest rates across financial markets have already risen sharply, creating more expensive financing conditions for households, businesses and governments.
Financial Stability May Influence the ECB
Financial stability could ultimately become an important factor in the ECB’s next interest rate decision.
Borrowing costs have increased significantly, partly because rising US Treasury yields have pushed global bond yields higher.
Investors are also demanding larger premiums to hold riskier European debt.
The gap between French and German government bond yields has widened to levels not seen for decades, raising additional concerns about debt sustainability and financial-market stability.
Against this backdrop, economists believe the ECB may prefer to remain cautious rather than add further pressure to already volatile financial markets.
Unless inflation accelerates substantially, policymakers may decide that immediate and aggressive monetary tightening is unnecessary.
