Rising inflation presents ECB with another dilemma

Eurozone inflation unexpectedly increased in July, dealing another blow to the European Central Bank (ECB), which is already second-guessing its decision to cut interest rates.

According to Eurostat, consumer prices in the 20-nation eurozone rose 2.6% annually in July, exceeding June’s 2.5% rate and higher than what economists expected.

Core inflation, which excludes volatile food and energy prices, remained stable compared to a year ago, against expectations for a slight decrease.

Although service inflation remains elevated, it moderated slightly to a 4% annual rate in July—the first slowdown in three months.

“Services inflation remains sticky at an uncomfortably high rate, even though it declined slightly. The rise in the headline figure and the stubbornness of the core number will raise eyebrows as well,” wrote Bloomberg economist David Powell.

While the uptick in headline inflation doesn’t seem like much, it could complicate the ECB’s decision for its next move.

Powell explained, “The stickiness of underlying price increases will keep the Governing Council cautious as it considers the timing of additional rate reductions.”

In June, central bankers voted to cut interest rates even as inflation was showing signs of accelerating again. For some economists, this was a bold—and slightly foolish—move.

The irony wasn’t lost on macro analyst Sven Henrich, who said: “ECB cuts rates while increasing its inflation forecast. Perfect.” After that apparent folly, ECB officials appear to have learned their lessons.

Slow and steady wins the race

In the wake of the ECB’s first rate cut in five years, policymakers have attempted to temper market expectations of additional rate reductions.

Economists say investors should monitor service inflation closely to determine whether the central bank will lower rates at its upcoming meeting in September.

This was the main takeaway of recent comments from ECB Executive Board member Isabel Schnabel, who said deviations in inflation data “can ultimately turn out to be a one-off, but they could also be more systemic.”

Schnabel said this is why the ECB is so concerned about service inflation, as this metric “has several times been higher than expected of late.”

“Until services inflation falls more significantly, the ECB is likely to continue to ease policy only slowly,” Franziska Palmas, an economist at Capital Economics, told The Wall Street Journal.

Unfortunately, the latest inflation report is “a difficult print for the ECB,” said HSBC economist Fabio Balboni. That means policymakers will likely tread carefully until prices cool.

Economists in a Bloomberg survey noted inflation as the biggest risk facing the eurozone economy, followed by the U.S. elections, and geopolitical tensions.

These factors are expected to keep the ECB on its toes ahead of its next policy meeting.