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Expected pick-up in eurozone inflation raises doubts over rate cuts

Expected pick-up in eurozone inflation raises doubts over rate cuts

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Inflation is expected to have jumped back up across much of Europe, casting doubt over investors’ hopes that the European Central Bank will start cutting interest rates as early as March.

French figures released on Thursday morning showed inflation rising in line with economists’ expectations to 4.1 per cent in the year to December, up from 3.9 per cent in November after a phase out of energy subsidies.

Inflation is likely to rise more sharply in Germany, where data due to be released on Thursday afternoon is expected to show a jump in annual consumer price growth to 3.8 per cent in December, up from 2.3 per cent a month earlier, according to economists polled by Reuters.

Consumer price growth in the eurozone has been slowing for six months, bringing it close to the ECB’s 2 per cent target. Bond and equity markets rallied in the final weeks of 2023 as investors bet borrowing costs would start to fall in the spring.

However, the reduction of government subsidies on gas, electricity and food that began last year is expected to trigger a re-acceleration of annual inflation in much of Europe.

The pick-up in inflationary pressure reflects a comparison with a year earlier when Berlin paid the gas bills of most households and Paris heavily subsidised electricity costs — driving down the cost of utility bills temporarily. 

Prices also look set to be pushed up after the German government was forced to scrap several other subsidies and increase taxes to help fill a €60bn hole in its budget plans left by a constitutional court ruling against its use of off-balance sheet funds.

“The expected increase in German inflation in December, but also the prospects of a further re-acceleration of German inflation as a result of the fiscal woes should be enough to push back markets’ rate cut expectations,” said Carsten Brzeski, global head of macro at Dutch bank ING.

One area where prices could rise in response to lower government subsidies is eating out, after Berlin raised the VAT rate on restaurant meals from a temporarily reduced level of 7 per cent back up to 19 per cent at the start of this year. 

Figures for the overall eurozone, due on Friday, are expected to show inflation rose from 2.4 per cent in November to 3 per cent in December, ending six months of consecutive declines.

Line chart of Harmonised index of consumer prices (annual % change) showing Price pressures are set to surge back up in the eurozone

Investors will be watching the figures closely for signs of how soon the ECB is likely to start cutting rates, after raising its benchmark deposit rate sharply from below zero to 4 per cent in response to the biggest surge in prices for a generation.

Swap markets are pricing in about 1.6 percentage points of rate cuts by the ECB this year, with a 60 per cent chance of cuts starting in March.

However, the ECB last month pushed back against speculation about imminent rate cuts, forecasting inflation in the bloc would rise from an average of 2.8 per cent in the fourth quarter of last year to 2.9 per cent in the first quarter of this year.

Isabel Schnabel, an ECB executive board member, said last month that inflation may “pick up again temporarily” because of energy prices and the withdrawal of various government support measures.

She predicted inflation would then “gradually” drop to the ECB’s 2 per cent target by 2025, adding: “We still have some way to go.”

Almost 60 per cent of respondents in a Financial Times survey of economists last month predicted eurozone inflation would slow to the 2 per cent threshold in 2024, although some said it was likely to speed back up again from there.