The European Central Bank (ECB) is facing a dilemma as the inflation rate in the euro-area slows more than expected. According to Eurostat, January’s inflation rate came in at 8.5%, which is lower than the economist’s predictions of 8.9%. The slowdown was driven by energy prices, although, a gauge of underlying inflation that eliminates volatile items remained at an all-time high of 5.2%.
This development may increase the number of dovish officials at the ECB who are advocating for a slower pace of rate hikes. They can point to factors such as the decline in natural gas prices due to a mild winter, the expected slowdown by the Federal Reserve, and a pause in the Bank of Canada’s monetary-tightening cycle. On the other hand, more hawkish officials are concerned about the rising wages and the sticky core inflation.
ECB President Christine Lagarde warned in December that there is “good reason to believe” that inflation numbers in the first two months of 2023 could be higher, which could strengthen the case for more aggressive rate hikes. Meanwhile, a positive economic outlook could put upward pressure on prices. This week’s data showed that the euro-area economy is avoiding a recession, the manufacturing industry is recovering, and unemployment remained at a record-low in December.
The uncertainty over inflation has been heightened by annual adjustments in the calculation methods, as well as the changes in how some governments protect households and firms from rising energy costs following Russia’s invasion of Ukraine. The situation became even more confusing when Germany’s statisticians announced technical problems that prevented them from providing January’s figures this week. Eurostat has made its own estimate for Europe’s largest economy, although it didn’t specify the amount.
The results of the ECB’s most aggressive tightening cycle in its history will not be fully visible until the second half of the year. The focus this week will be on President Lagarde and her thoughts on the meeting in March and beyond. According to a Bloomberg poll of economists, the ECB will deliver 50 basis-point rate hikes in February and March, followed by a final 25 basis-point hike in May, with the deposit rate settling at 3.25%.
In conclusion, the ECB is facing a challenging situation as the inflation rate slows, and the officials are divided over the pace of rate hikes. President Lagarde has indicated her commitment to ensuring the timely return of inflation to the target of 2%. The final inflation reading by Eurostat is due on February 23.
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