Euro zone inflation accelerated further last month, driven by energy and services, bolstering the already strong case for a small European Central Bank interest rate hike later this month, Eurostat data showed on Tuesday.
Consumer prices in the 21 nations sharing the euro accelerated to 3.2% in May from 3.0% a month earlier, well above the ECB's 2% target but in line with a Reuters poll. The increase was driven by a 10.9% rise in energy costs and an unexpectedly large pickup in services inflation to 3.5% from 3.0%. Get a daily digest of breaking business news straight to your inbox with the Reuters Business newsletter.
In a development likely to worry policymakers, underlying inflation - which excludes volatile energy and food prices - accelerated more than expected to 2.5% from 2.2% on services and a small pickup in industrial goods inflation. "The further increase in headline and particularly services inflation in May reinforces the case for the ECB to raise interest rates next week and suggests that upside risks to underlying inflation may be higher than we had anticipated," Andrew Kenningham at Capital Economics said. While the figures are closely watched by the ECB, they are unlikely to shift near-term policy expectations. Policymakers have already made clear that higher inflation justifies an increase in borrowing costs.
Financial markets have fully priced in a 25-basis-point rate hike on June 11, with one or two more expected in the autumn. Elevated energy prices risk seeping into the broader economy and triggering more persistent inflation pressures. "While inflation risks have increased, a rate increase in June would be an insurance one, but not due to entrenched inflationary pressures," Finnish central bank chief Olli Rehn, a dovish voice on the ECB's Governing Council, said.
Even if the Iran war were to end soon, the argument goes, damage to energy infrastructure and corporate supply chains has already been done, making normalisation slow and keeping prices high well into the second half of the year. Still, any tightening is expected to be modest - far less aggressive than the record series of rate hikes in 2022 - as weaker underlying growth limits firms' ability to pass on higher costs. The dollar has been trading in a tight range for the last couple of weeks as investors lack signals to go on.
Indicators from PMI surveys to the ECB's own data point to growing pressure on the real economy, and further downgrades to already subdued rowth forecasts look likely as the Iran war drags on and high energy prices weigh. Europe is a net energy importer and its industrial sector - already hit by the loss of cheap Russian gas following Russia's invasion of Ukraine and by higher U.S. tariffs - is reeling. Households are sitting on ample savings and could sustain spending, but past experience suggests consumers are quick to turn cautious when the newsflow darkens.
Unlike during the 2022 inflation surge, the labour market is also softer, reinforcing that caution, economists say. That suggests high energy prices may generate fewer second-round effects on inflation than four years ago, easing some pressure on the ECB to act aggressively.
"Interest hike is becoming inevitable for the ECB," Commerzbank economist Vincent Stamer said. "Another rate hike in the third quarter is also likely to follow."
