Copy of 2023-03-13T061344Z_462006766_RC2TSZ9KKUT4_RTRMADP_3_EUROZONE-MARKETS-ECB-1680259898599
Money markets appeared to focus on the decline in headline inflation, paring rate-hike wagers. Image Credit: REUTERS

Brussels: Underlying inflation in the euro area hit a record in March, handing ammunition to European Central Bank officials who say interest-rate increases aren’t over yet.

The rise to 5.7 per cent in the core price reading, which strips out volatile items like fuel and food costs, came alongside a record plunge in headline inflation to 6.9 per cent from 8.5 per cent in February.

As the energy spike that followed Russia’s attack on Ukraine drops out of inflation readings, ECB officials are increasingly focused on the underlying measure - reflecting concern over firms hiking prices and workers demanding higher salaries to make up for lost purchasing power.

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Divergence in the two price gauges can be seen in the region’s biggest economies, with underlying price growth barely budging in Spain even as the headline measure almost halved to just 3.1 per cent.

Money markets appeared to focus on the decline in headline inflation, paring rate-hike wagers. Investors are pricing a 3.61 per cent peak by October compared with as high as 3.71 per cent before Friday’s data. Germany’s two-year yield was 2 basis point higher at 2.73 per cent, having earlier risen to 2.83 per cent.

The ECB last month raised its main rate to 3 per cent but offered no guidance on what happens next, citing the financial turmoil. Since then however, several policy makers have insisted more tightening will be necessary.

After 3.5 percentage points of rate increase since last July, ECB President Christine Lagarde said this month that officials “will be looking to see a sustained downward turn in underlying inflation measures to be confident that the inflation path will converge to our target in the medium term.”

Returning to that 2 per cent goal has become more complicated in recent weeks due to turbulence in the financial sector that culminated in UBS Group’s takeover of Credit Suisse Group.

Bigger effect

While the upheaval may lead to more restrictive lending - a disinflationary force - “it’s completely open for now how big that effect” will be, ECB Executive Board member Isabel Schnabel said this week.

For now, the banking stress is easing - prompting more hawkish ECB policymakers to urge further rises in borrowing costs.

Such calls are backed by an economy that’s proved surprisingly resilient in the face of the energy crisis. Surveys by S&P Global pointed to firmer business activity in March, albeit driven exclusively by the services sector.

The labor market has also remained robust throughout the war in Ukraine, with separate data Friday showing unemployment stable at 6.6 per cent in February.

There may be a downside to such developments, however. ECB economists warned Thursday in a blog post that a feedback loop involving higher wages, widening corporate profit margins and rising prices “risks strong second-round effects.”