Inflation in the euro zone rose above expectations in September, and is likely to continue rising in the coming months, driven by rising energy costs, keeping the European Central Bank under pressure to raise interest rates to higher levels.
The inflation rate in the 21 countries that use the euro jumped to 3.8 percent in September, compared to 3.2 percent in the previous month, exceeding the expectations of a Reuters poll of 3.6 percent, driven mainly by higher fuel and natural gas prices, and to a lesser extent by food costs.
Meanwhile, data released on Friday by Eurostat, the European Union's statistics office, showed core inflation, which is closely monitored and excludes volatile food and fuel prices to show underlying trends, rose to 2.5 percent from 2.4 percent, as a result of higher service prices.
These numbers are likely to have mixed meanings for the European Central Bank.
The rise in general inflation to levels that further exceed the bank’s target of 2 percent raises concerns, and may reinforce demands to raise interest rates again, after the two increases approved this summer.
However, the limited rise in core inflation indicators indicates that rising energy costs have not yet led to the emergence of “second wave” effects, which may spark an inflationary spiral that is difficult to contain.
These data indicate the possibility of the European Central Bank sticking to its “studied” policy response, which is a concept that is not precisely defined, but the markets interpret it to mean raising interest rates at distant intervals, perhaps coinciding with the issuance of quarterly economic forecasts.
In fact, investors expect up to three more increases in the European Central Bank's deposit interest rate, currently at 2.5 percent, over the next year, but the odds of such a step being taken this month are very slim, and markets are not fully taking into account another increase before January.
However, these forecasts are changing rapidly, and even policymakers themselves acknowledge that their forecasts are fraught with a high degree of uncertainty. Advocates of lower interest rates argue that energy costs have been too high for too long, inevitably causing side effects, and that the recent rise in natural gas prices will impact core prices at a faster pace than before, pushing up the prices of everything from electricity and heating to business expenses.
In contrast, others argue that the labor market is relatively weak, making it difficult for workers to demand large wage increases, and that the recent sharp rise in long-term borrowing costs will in turn suppress price growth.
Ultimately, the deciding factor in the next interest rate decision may be financial stability considerations, not inflation.
Borrowing costs have risen significantly, mostly due to the sharp rise in US bond yields to their highest levels in 24 years, affecting all borrowers. But investors are also demanding a higher premium for holding riskier assets, while the spread between yields on French debt and similar German bonds has widened to its highest levels in decades, raising questions about the sustainability of the debt.
Economists say that the European Central Bank may prefer to remain neutral at the present time and not fuel unrest, especially since inflation trends do not require urgent or decisive action.
Finnish Central Bank Governor Olli Rehn said on Friday that energy prices were approaching the “negative” scenario set by the European Central Bank, but the sharp rise in long-term borrowing costs limited the extent to which the impact of this inflation would be transmitted to the broader economy.
The inflation rate has clearly exceeded the 3 percent barrier in recent months, and may approach 4 percent by the end of the year, that is, double the target set by the European Central Bank, which increases pressure on the bank to raise interest rates again after two increases approved this summer, according to Reuters.
While the European Central Bank stated that the risks are towards higher than expected inflation rates, Rehn noted that there are risks in both directions.
“The rise in energy prices brings us closer to the negative scenario of the European Central Bank regarding inflation,” he said at a conference of the European Systemic Risk Council.
“On the other hand, higher long-term interest rates will slow growth and reduce the transmission of the energy shock to other prices and wages,” Ren added. “This confirms that growth and inflation expectations are still subject to a very high and comprehensive degree of uncertainty.”
Government borrowing costs have risen sharply in recent weeks, largely reflecting rising yields in the United States, amid concerns that Washington's fiscal policy is on an unsustainable path.
Yields also rose as the world's largest technology companies issued record levels of debt to finance their investments in artificial intelligence, crowding out other borrowers, including governments, from the market.
At 3.57 percent, the 10-year borrowing cost in Germany, which is considered one of the safest borrowers, reached its highest level in 17 years, while the yield on similar US bonds is 5.32 percent.
Ren also warned that borrowing by technology companies poses a risk to financial stability, given the significant rise in valuations, making a price correction possible.
“A sharp correction in AI-related valuations could extend its impact to stock and credit markets,” Ren said. History teaches us that technological revolutions can transform economies, but it also shows that financial markets may overestimate their immediate returns.
However, Ren said the euro zone economy was showing surprising resilience, and growth rates were withstanding higher energy costs better than feared.
