Eurozone inflation ticks up in May but unlikely to stop ECB June cut

Eurozone inflation rose in May, signaling that the European Central Bank (ECB) still faces challenges in fully reining in prices, according to data released on Friday.

Despite the larger-than-expected inflation increase, the ECB is still anticipated to lower borrowing costs from a record high next week. However, this may strengthen the case for a pause in July and a slower pace of interest rate reductions in the upcoming months.

Dirk Schumacher, an economist at Natixis, said in a comment to Reuters:

“These numbers strengthen the hands of those who say we need to be cautious”.

Consumer prices in the 20 countries using the euro rose by 2.6% year-on-year in May, moving further away from the ECB's 2% target after 2.4% increases in the previous two months, Eurostat's flash estimate showed.  

Economists polled by Reuters had predicted the Eurozone inflation rate to rise to 2.5%, influenced partly by an unfavorable comparison to last year when Germany had subsidized rail travel and other temporary factors.

ECB’s Fabio Panetta says May Eurozone inflation reading neither good nor bad

ECB policymaker Fabio Panetta, the governor of the Bank of Italy, commented that the latest Eurozone inflation reading was neither good nor bad, reaffirming his view that the central bank could cut rates multiple times while still maintaining economic restraint.

A significant measure of underlying inflation, excluding food, energy, alcohol, and tobacco, rose to 2.9% from 2.7% in April. Prices in the services sector, particularly noted by policymakers due to their reflection of domestic demand, increased to 4.1% from 3.7%.

This rise in service sector prices is likely linked to higher-than-expected wage increases in the first quarter of the year, which have improved consumers' disposable incomes after years of below-inflation pay hikes.

ECB interest rate cut expected at policy meeting next week

The ECB's unprecedented streak of rate hikes has helped reduce inflation, which peaked at 10% in late 2022 following the surge in energy prices after Russia's invasion of Ukraine. These hikes have stabilized consumer inflation expectations but also restricted credit.

Policymakers meeting next week are expected to stick to well-publicised plans to cut rates despite growing market doubts of a global narrative of falling inflation. Notably, inflation has proved stickier in major economies such as the U.S. and Australia. The Australian inflation rate recently ticked up to a hotter-than-expected 3.5% in April, with the country’s central bank expected to keep interest rates elevated until mid-2025.

Diego Iscaro, head of European economics at S&P Global Market Intelligence, was cited by Reuters as saying: 

“We think that the latest inflation and wage figures decrease the likelihood of back-to-back interest rate cuts in July, but we see the ECB cutting rates twice more before the end of the year if the downward trend in inflation resumes during the third quarter as expected”.

Following the Eurozone inflation data release, German government bond yields, the benchmark for eurozone borrowing costs, reached their highest level in over six months.

The euro to dollar rate last stood at $1.0856, up 0.2% ahead of the U.S. inflation reading, due later today.

Markets currently anticipate around 57 basis points of ECB interest rate cuts in 2024, including a 25 basis point cut in June and another by the end of the year. Expectations of a third cut this year, however, have been gradually reduced in recent weeks.