Eurozone Inflation Gains Momentum As Energy Prices Surge

• Eurozone inflation rose to 3.2% in May.

• Energy and services costs drove the latest inflation increase.

• Markets expect the ECB to raise rates this month.

Eurozone inflation accelerated in May, driven by higher energy and services costs, reinforcing expectations that the European Central Bank will raise interest rates later this month, according to data released by Eurostat on Tuesday.

Consumer prices across the 21 countries that use the euro rose 3.2% year-on-year in May, up from 3.0% in April.

The increase was largely attributed to a sharp rise in energy prices and continued strength in the services sector.

Energy costs climbed 10.9%, while service prices increased 3.5%, contributing significantly to the overall inflation figure.

Underlying inflation also moves higher

A development likely to attract the attention of ECB policymakers was the increase in underlying inflation.

This measure excludes more volatile components such as energy and food prices and is often viewed as a better indicator of longer-term price pressures.

Underlying inflation rose to 2.5% in May from 2.2% in April.

The increase was supported by higher services inflation and a modest acceleration in industrial goods prices.

Despite the rise in both headline and core inflation measures, the data is not expected to significantly alter near-term monetary policy expectations.

ECB officials have already signalled that elevated inflation levels justify tighter borrowing conditions.

Markets firmly expect June rate hike

Financial markets have largely priced in a 25-basis-point interest rate increase at the ECB’s June 11 meeting.

Investors are also anticipating one or two additional rate increases later in the year.

Concerns remain that elevated energy prices could spread more broadly through the economy and create more persistent inflationary pressures.

Policymakers are closely monitoring whether higher energy costs feed into other sectors and become embedded in future price-setting behaviour.

According to the prevailing view, even if ongoing geopolitical tensions were resolved in the near term, damage to energy infrastructure and corporate supply chains has already occurred.

As a result, normalisation is expected to be gradual, keeping energy prices elevated through much of the second half of the year.

Growth concerns limit scope for aggressive tightening

While further policy tightening appears likely, economists expect any rate increases to be relatively modest compared with the aggressive tightening cycle seen in 2022.

Weaker underlying economic growth is limiting the ability of businesses to pass rising costs on to consumers.

Several indicators, including Purchasing Managers’ Index (PMI) surveys and the ECB’s own data, point to increasing pressure on the real economy.

Analysts also expect further downgrades to already subdued growth forecasts as the Iran war continues and high energy prices weigh on economic activity.

Europe’s position as a net energy importer leaves it particularly vulnerable to rising energy costs.

The region’s industrial sector is already facing significant challenges following the loss of inexpensive Russian gas after Russia invaded Ukraine.

Higher tariffs imposed by the United States have added to those pressures.

Consumers and labour market in focus

Households continue to hold substantial savings, which could help support consumer spending.

However, experience suggests consumers often become more cautious when economic uncertainty increases.

Economists note that, unlike during the inflation surge of 2022, the labour market is now showing signs of softness.

That trend could reinforce consumer caution and reduce the risk of a strong wage-price spiral.

As a result, some analysts believe that although higher energy prices may continue to push inflation higher, they could generate fewer second-round inflation effects than they did four years ago.

This may reduce pressure on the ECB to pursue a more aggressive path of monetary tightening.

Meanwhile, broader market sentiment remained relatively stable, with the S&P 500 gaining about a quarter of a percent and the Nasdaq rising just over four-tenths of a percent.