3.4% eurozone inflation puts more heat on the ECB

Eurozone inflation just came in at 3.4% year-on-year in September, from 3.0% in August. A 13-year-high. Core inflation accelerated to 1.9%, from 1.6% in August.

The surge in headline inflation is still mainly driven by so-called one-off factors such as higher energy prices, the German VAT reversal or price mark-ups post-lockdown in the leisure and hospitality services. However, higher inflation has been spreading across the entire economy, with almost half of the major 100 components in the consumer price basket recording inflation rates of above 2%.

Today’s inflation surge will do very little to bridge the gap between the two inflation camps, the ‘transitory’ and the ‘more persistent’ camps. While the recent rise in energy prices and the prospect of supply chain frictions lasting far into 2022 are giving the ‘transitory’ camp a hard time, slack in the labour market and some base effects disappearing next year still undermine the ‘more persistent’ view.

We see two kinds of second-round effects materialising

In our view, some one-off factors should indeed fade away next year but inflation could turn out to be stickier than the ‘transitory’ camp currently assumes. In fact, we see two kinds of second-round effects materialising, keeping inflation higher than expected next year.

The first is the pass-through from higher producer prices to consumer prices. In the past, producers absorbed higher costs by squeezing profit margins. This time around, they seem to be willing to pass on higher costs to consumers as illustrated by the fact that selling price expectations in both the manufacturing and services sector are currently at or are close to record highs. The second pass-through channel will be wages. The mismatch in the labour market between the lack of skilled workers and still high unemployment rates as well as a re-regionalisation of production as a result of supply chain frictions could give rise to higher wages.

Admittedly, monetary policy can hardly bring down inflation driven mainly by one-off factors. However, constantly higher inflation rates and a high risk that the ECB has actually entered a period in which its longer-term inflation forecasts frequently turn out to be too low, compared with too high in the years prior to the pandemic, will put more pressure on how much monetary accommodation the eurozone economy really needs. With today’s inflation data, the ECB’s own forecasts have once again been too low. The September staff projections had headline inflation at 2.7%, it now comes in at 2.9%.

This week’s speech by ECB president Christine Lagarde already signalled a changed stance on inflation compared with a few months ago; a shift from a very benign assessment to one of more alertness and awareness that inflationary pressure might be less short-lived than initially thought. This marks already some convergence between doves and hawks at the ECB but we still expect a heated debate at the December meeting. Recent and future inflation developments are still no reason at all to discuss policy rate hikes but definitely a reason to discuss a (more significant) reduction of the asset purchases and not just a recalibration.