Euro Zone Inflation Surges Past ECB Target on Oil Shock

Euro zone inflation surges past ECB target on oil shock

Euro Zone Faces Inflation Surge Amid Oil Shock

By Balazs Koranyi

FRANKFURT, March 31 (Reuters) - Euro zone inflation soared past the European Central Bank's 2% target this month due to surging oil and gas prices, heightening a policy dilemma as expensive energy drags growth and risks generating a self-reinforcing inflation spiral. 

Impact of Oil Prices on Inflation

Oil prices have nearly doubled as a result of the Iran war and the ECB is now debating whether to raise interest rates to prevent this surge from becoming entrenched in the price of other goods and services.

Overall inflation in the 21 countries sharing the euro currency jumped to 2.5% in March from 1.9% a month earlier, below expectations for 2.6% in a Reuters poll of economists, as energy costs rose 4.9%.

Expert Commentary on Inflation Trends

"The previously price-stable environment is saying goodbye" said Alexander Krueger, chief economist at Hauck Aufhaeuser Lampe. "What matters is that this inflationary dirt does not feed through into the core rate."

A closely-watched figure on underlying inflation, which excludes volatile food and energy, meanwhile, fell to 2.3% from 2.4%, data from Eurostat, the EU's statistics agency showed on Tuesday.

ECB Policy Dilemma: Hike or Look Past?

Debate Over Interest Rate Response

HIKE OR LOOK PAST?

Basic economic theory argues that central banks should look past one-off price shocks generated by supply disruptions, especially because monetary policy works with long lags.

But a quick rise in energy inflation can easily broaden out if companies start building this into selling prices and workers begin demanding higher wages for the loss of disposable income.

Forecasts and Market Expectations

High energy prices should increasingly make other goods more expensive and push up core inflation, said Commerzbank's chief economist Joerg Kraemer, forecasting headline inflation will rise above 3% by May unless the war ends quickly.

The public may also start doubting the ECB's resolve if it remains idle, firming the case for rate hikes even in the event of large but not so persistent inflation episodes, ECB President Christine Lagarde said last week.

Financial markets now see three interest rate hikes from the ECB this year, with the first in either April or June. 

"The mounting inflation pressure suggests that the ECB will raise its key interest rates in April or, at the latest, in June," Kraemer said.

Policymaker Perspectives

While some policymakers, such as the influential Bundesbank head Joachim Nagel, said that a rate hike as soon as April was an option, others, including ECB board member Isabel Schnabel, have warned against hasty action. 

But policymakers agree that the ECB must act if energy starts generating second round price pressures, especially since domestic inflation had been above 2% for years.

Comparisons to Past Inflation Episodes

Services Inflation and Domestic Trends

Services inflation, the single largest item in the consumer price basket and the key gauge for domestic inflation, fell to 3.2% in March from 3.4% a month earlier.

ECB’s Historical Response

Part of the issue is that the ECB was late in recognising the inflation problem in 2021/22, arguing for months that the surge was transitory and would pass. It only raised rates when price growth hit 8%, forcing the central bank into its steepest tightening cycle in its history. 

But the bloc is now in a very different position, so comparisons with 2022 are not entirely valid. 

Current Economic Conditions

Rates are already higher, budget policy is tighter, the labour market has been weakening for months and there is no pent-up demand created by pandemic-era lockdowns. 

Looking Ahead: ECB’s Next Steps

The ECB will next meet on April 30. 

"We find it hard to see the ECB moving at the next meeting at the end of April," said Carsten Brzeski, global head of macro at ING. "Unless the ghosts of 2022 are really keeping policymakers awake at night."

(Reporting by Balazs Koranyi and Maria Martinez; Editing by Alexander Smith and Arun Koyyur)