Lowest inflation in Eurozone in 3 years leads to ECB cut

Eurozone inflation fell to a three-year low in August, paving the way for a further cut in interest rates from the European Central Bank next month despite an Olympics-driven rise in services prices.

The ECB has started to unwind a two-year campaign against high inflation, which followed the rapid reopening of the economy after the COVID-19 pandemic and Russia’s invasion of Ukraine.

Inflation in the 20 countries that use the euro as their currency fell to 2.2% this month, the lowest level since July 2021 and close to the ECB’s 2% target, according to a preliminary measurement by Eurostat, the European Union’s statistical office.

While the decline was mainly due to lower energy prices and may be reversed later this year, the ECB is likely to implement a second rate cut on September 12, following the first step in June.

“The significant drop in headline inflation in August makes a cut in September a foregone conclusion,” said Tomas Dvorak, chief economist at Oxford Economics.

Even ECB board member and prominent policy influencer Isabel Schnabel appeared to open the door to further easing on Friday, saying that further gradual rate cuts might not disrupt the disinflation process, as some policymakers had feared.

Still, the report found that price growth in the services sector (which policymakers watch closely because it better reflects domestic demand than external conditions) accelerated to 4.2% from an already high 4.0%.

This was likely the result of a boost from the Paris Olympics, but also from increased purchasing power among workers following some recent wage increases.

“This is likely the result of a relatively tight labour market, as evidenced by the decline in the unemployment rate in July,” said Gian Luigi Mandruzzato, senior economist at EFG Asset Management.

Markets are currently expecting six rate cuts before the end of next year. That is about one cut more than the ECB’s own economic forecasts. This indicates that markets are more optimistic about the price outlook than the ECB.

This is partly because market economists expect a bigger fall in inflation this autumn than ECB staff itself.

Policymakers say they will only have confidence in inflation expectations if wage growth slows. The German central bank in particular has been vocal about this risk.

However, with inflation barely below the ECB’s target, it is likely that eurozone central bankers will broaden their debate from a one-sided focus on inflation to include signs of economic weakness.

Wage growth has slowed sharply and unemployment is already rising in about a quarter of the eurozone’s 20 countries. Survey data from businesses and households suggest that further deterioration in the labour market is on the horizon.

Since the ECB raised interest rates last year, lending has slowed to a minimum, drying up investment and hampering credit-dependent sectors such as construction and industry.

As a result, economic growth in the eurozone has barely gotten off the ground for more than a year. The weakness of industrial powerhouse Germany only partly offsets the strength of service-providing countries such as Spain.

“We believe the ECB is already lagging behind. It is focusing too much on the current and limited inflation numbers and not paying enough attention to the weak growth, with potentially damaging long-term consequences,” said Dvorak of Oxford Economics.