How will the ECB respond to sky-rocketing inflation?

National data point to headline inflation of almost 8%

The first eurozone countries have published HICP inflation data for March, with the inflation rates all shooting higher. Germany and Spain each reported a spectacular rise by more than two full percentage points; Germany to 7.6% yoy in March, up from 5.5% in February, and Spain to 9.8% from 7.6%. Belgium has only published inflation according to the national (non-harmonised) definition, which rose to 8.3%, up from 8.0%. The details that have been published so far reveal that soaring energy prices remained the main driver behind the jump in inflation. Indeed, some German states reported rises in household energy price inflation from around 20% yoy in February to around 40% in March (gas price inflation in some cases doubled to around 70%), while car fuel inflation rates in some regions rose from around 25% to around 50%. In Belgium energy price inflation came in at 57.2% in March, contributing 4.8 percentage points to total headline inflation of 8.3%. Besides energy prices, food commodity prices have also soared in recent months, with food price inflation also jumping higher in March, in many German regions from around 5-6% to around 6-7%.

Although energy and other commodity prices have remained the main drivers of inflation, core inflation has also increased in March. In Spain by 0.4 percentage points to 3.4% and in Belgium by 0.5 percentage points to 3.75%. The rise in core inflation can be explained by a number of factors at the moment. To begin with, high energy price inflation tends to filter through quickly into the price of transport services. Next, the inflation rate of holiday and leisure related services is temporarily lifted at the moment, due to normalisation of prices following lockdowns (a number of German states reported yoy rises in the price of package tours of more than 11% in March; Belgium reported a rise in the price of holiday villages by 24.6% yoy). Finally, supply chain disruptions have also raised the inflation rate of global industrial goods. These disruptions have been intensified by the Ukraine war and sanctions on Russia, which came over and above disruptions related to new pandemic-related lockdowns in China.

The eurozone inflation rate for March will be published on 1 April. The consensus forecast is that it will rise from 5.8% in February to 6.7% in March, but the data for the individual countries suggest that inflation will come in well above this expectation, probably around 7.5-8%. Looking forward, inflation should remain elevated for a while and remain a lot higher than the ECB target throughout this year. Meanwhile, underlying inflation is subdued. Wage growth has eased in recent quarters and was only around 1.6% yoy in 2021Q4. Moreover, labour market slack should increase this year as the economic slowdown reduces employment growth. We expect core inflation to fall noticeably from around the middle of this year onwards. For a start because a number of the factors mentioned above that temporarily lift core inflation at the moment should peter out, but also because underlying inflationary pressures remain subdued.

ECB View: Weaker than expected growth an important counterbalance to inflation surprises

Recent data suggest that inflation is again likely to surprise the ECB’s projections to the upside in the coming months. The ECB projects HICP inflation of 5.6% for Q1, but the early data suggests it will probably average around 6.2%. However, there is a flipside to this coin. Given the rise in inflation is almost exclusively driven by the supply side, the higher inflation gets, the weaker economic growth will be. In particular, real wages are collapsing right now and that will weigh heavily on consumer spending. Indeed, economic growth is likely to disappoint ECB projections as well. How will the ECB balance these forces? Weaker growth should on its own lead to downward revisions in the medium term inflation outlook. Higher current inflation outcomes do not necessarily lead to higher outcomes over the medium term, but the big caveat here is second round effects. Inflation expectations (according to market prices and surveys) have risen significantly but are now broadly in line with the ECB’s inflation target, rather than a threat to it. Meanwhile, as noted above, wage growth is actually at levels below those consistent with the goal (around 3% is consistent with the ECB’s inflation target). If we were to see sharp rises in inflation expectations or wages on the back of the inflation surprises, this would trigger more aggressive tightening from the ECB. However, that does not seem likely to us given the deteriorating economic outlook. While the APP is likely to end in Q3 of this year, we think that modest rate hikes – at most – are likely to follow. The more than 60bp of policy rate hikes priced in by financial markets for this year look overdone to us against this background.