Underlying inflation is likely to have reached its peak in the first half of this year, according to the European Central Bank (ECB), although there remains a “high degree of uncertainty” about the actual levels. The ECB is now shifting its focus to domestic inflationary pressures, which are becoming more prominent as external pressures leading to rising inflation begin to ease.
In its analysis of underlying inflation, the ECB stated that while it remains high overall, data suggests that it likely peaked in the first half of this year. This trend is broadly in line with the ECB’s projections from June. Underlying inflation refers to the measure of inflation that would be expected in the absence of economic or supply shocks.
ECB chief economist Philip Lane, speaking on the ECB’s podcast, expressed confidence that falling energy prices would bring down costs across the economy. However, he also highlighted that domestic inflation is becoming a growing concern. He explained that the high inflation seen last year is now pushing up wages, and rising wages, along with firms looking to rebuild profits, are contributing to underlying inflation.
The ECB noted that there appears to be a decline in services inflation, which may have already begun. The easing of supply bottlenecks suggests that goods inflation is less likely to persist, while the dynamics of services inflation may determine the overall persistence of headline inflation.
The ECB’s next meeting to discuss the potential for further interest rate hikes is scheduled for September 14. Since July last year, interest rates have already risen by 4.25%. Annual inflation in the eurozone was at 5.3% in July, well above the ECB’s medium-term target of 2%. However, recent estimates by the Central Statistics Office indicate that annual inflation in Ireland dropped to 4.6% in July.
Whether or not there will be another increase in interest rates during the September meeting, or at the two other meetings scheduled before the end of the year, will depend on economic and financial data, underlying inflation dynamics, and the effectiveness of tightening monetary policy. ECB President Christine Lagarde has stated that inflation is still expected to be too high for too long, and interest rates will be set at sufficiently restrictive levels for as long as necessary.
The ECB attributed the surge in inflation since 2021 to extraordinary relative price shocks related to the post-pandemic recovery, supply bottlenecks, and the increase in energy prices, partly due to Russia’s war against Ukraine. The ECB also noted that standard measures of underlying inflation may contain a significant reverting component that is expected to fade out over the medium term.
Overall, the ECB’s analysis suggests that underlying inflation has likely peaked, but there is still uncertainty about the actual levels. The focus is now shifting to domestic inflationary forces, particularly rising wages and firms’ efforts to rebuild profits. The decline in services inflation and the easing of supply bottlenecks are expected to have an impact on overall inflation. The ECB’s decision on further interest rate hikes will depend on various factors, including economic data and the effectiveness of monetary policy.