Commentary Directory

Hot Services Inflation Sets Up the ECB for a Hawkish Announcement

Jacob Hess
May 02, 2023

If this inflation report was to provide some color to the ECB meeting this week, then that color is red. Euro area inflation was 0.7% MoM and 7.0% YoY in April, up from 6.9% YoY in March. The acceleration in the pace of annual inflation came even on the backs of an apparent peak in food inflation and another monthly decline in energy prices. The index for food prices grew just 0.2% MoM on the month which lead to a -1.9 ppts decline in the annual pace of price increases to 13.6% YoY. This is the lowest since November 2022. A further deceleration in food inflation could be observed if monthly gains stay muted as base effects start to have a major impact on the year-over-year comparison going forward. Energy prices declined -0.8% MoM which is a positive for sure, but some base effects led the annual pace to turn positive at 2.5% YoY after a brief period in negative territory at -0.9% YoY in March. This segment may continue to be volatile as energy markets in Europe settle on a consistent trend.

From Piet Haines Christiansen

The worrying trends came out of the core parts of inflation which are the ones that the ECB will be focused on in its meeting. As headline inflation has seen a consistent downtrend over the last few months, core inflation has been more resistant to downward pressure. In April, core inflation grew 1.0% MoM and 5.6% YoY which is only a slight decline from the 5.7% YoY pace recorded in March. The strong monthly pace means that core inflation is neutralizing base effects and keeping the annual rate of inflation near peaks. Non-energy goods prices saw a moderate pace of growth in April, up 0.7% MoM, which means that there was a small improvement in the annual pace, down -0.4 ppts to 6.2% YoY. This reading means that goods inflation has been above 6% for six months now which is troubling considering other developed countries like the US and Canada have seen clear downtrends in their goods inflation readings. It seems that supply chain disfiguration that is lingering from the Russia-Ukraine conflict remains the most impactful to the neighbors of the conflict.

While the dynamics of goods inflation are discouraging, services inflation is the real area of focus for the ECB because it has advanced again. Services prices were up a strong 1.2% MoM, pushing the annual pace to a new high of 5.2% YoY. The pressures from high wages and possibly from the lasting tenacity of demand from reopening effects. The former factor seems more likely the major driver of persistent services inflation. Employment trends in the euro area do not point to any major depressurization in wage growth as unemployment remains near all-time lows. Measures of wages in the euro area are only released on a quarterly basis, so it’s hard to be clued into where that is trending in non-quarter-ending months. The latest data point we got was for nominal labor costs in Q4 2022. In that report, labor costs growth had risen to a new high of 5.7% YoY with services labor costs up 6.2% YoY. It is hard to see how that has come down in Q1 2023.

While services inflation and wage growth dynamics play against the ECB, it does have some relief in the current trends in credit conditions. Today, its report on monetary policy found that the expansion of the euro area money supply is slowing. In fact, the narrow reading of money supply, the M1 monetary aggregate, was down -4.2% YoY in March (-2.7% YoY in February). The report also showed that lending to households and non-financial corporations was slowing which confirms the findings in the Q1 2023 bank lending report. In that report, the ECB notes that a net 27% of banks tightened lending standards in Q1 2023 which is the sharpest tightening since the 2011 debt crisis. ECB members will seek to balance inflammatory services inflation with the cooling of credit conditions. However, the former priority will likely take precedence in the meeting this week since the inflation number will be on everyone’s mind. The ECB will have to move by at least 25 bps (the likely option) and will likely prepare for another rate hike in the next meeting. Additionally, it will keep hawkish language in its communications to assure that markets understand its commitment to reducing inflation.