QNB Group’s weekly report confirmed that the European Central Bank raised official interest rates again in June, reaffirming the tightest monetary tightening cycle ever in its efforts to bring inflation back to its 2% target over the medium term. Since the beginning of the cycle in July 2022, increases in official interest rates have accumulated by 400 basis points, raising the key rate for refinancing operations to 4.00%, the highest rate since 2008. Although the upcoming decisions are expected to be more “balanced”. And based on the data received, the Board of Governors gave signs of the possibility of additional increases on the way, before turning to a “wait and see” mode to assess the impact of the monetary tightening cycle on the economy.
First, despite a significant decline in the headline inflation rate from its peak in October last year, core inflation remains very high. Core inflation excludes commodity-related prices, which are driven by external global factors rather than domestic developments. The trend of core inflation is particularly relevant to monetary policy because it reflects the effects of past decisions, and provides signals that raising interest rates has a fundamental effect on price growth.
The headline inflation rate peaked at 10.6% in October of 2022, and has since fallen by 4.5 percentage points to 6.1% in May this year. This is a significant improvement, but as we discussed in a previous article, it is largely due to lower energy prices, which have become more stable recently, and the margin to contribute to the decline in overall price growth through them is more limited. Core inflation, which excludes more volatile items such as energy and food products, has fallen by only 0.4 percentage point since peaking in March this year. The persistence of this rise has led the European Central Bank to revise its forecast for core inflation upwards, now expecting it to reach 5.1% in 2023, an increase of half a percentage point compared to its previous forecast published in March.
In addition, for the ECB, it is not enough just for inflation to fall, it stressed the need to raise interest rates to levels constrained enough to ensure that inflation returns to its medium-term target of 2% in due course.
Second, tight labor markets continue to raise labor costs and generate inflationary pressures. The unemployment rate has been declining since the beginning of the year and reached 6.5% in April, reaching a new historic low. In line with these aggravating circumstances, growth in unit labor costs reached an alarming rate of 5.8% in the first quarter of 2023, well above the pre-pandemic average of 1.2% in the 2015-2019 period. This situation reinforces the upward trend in labor costs and adds more concerns.
Going forward, tight labor markets combined with increases in the minimum wage are expected to fuel wage growth, which will remain more than double its historical average for most of the forecast period. This means that labor costs will continue to be the dominant driver of core inflation, providing an additional argument for the ECB to continue tightening interest rates.
Third, despite the slowdown in the economy, the ECB expects activity to pick up, and stressed the economy’s resilience in the face of the recent large negative shocks. The central bank expects growth in activity to pick up and remain “strong” in the second half of the year, as supply chain bottlenecks and energy shocks fade, and real income recovers as wages grow faster than headline inflation. Against the backdrop of these factors, the European Central Bank expects GDP to grow by 0.9% this year, before accelerating to 1.5% in 2024.
