Price Gains Ease in Europe but Core Inflation Keeps Policymakers ‘Up at Night’

A new year has brought Europe a little bit of good fortune. Unusually mild, even warm, weather has helped pull down natural gas prices after they soared for much of last year and sent inflation rates to record highs, upending the region’s economy.

With this luck in mind, analysts have strengthened their conviction that European inflation, the highest in generations, has peaked.Data earlier this month showed that consumer prices in the eurozone rose at an annual rate of 9.2 percent in December, down from 10.1 percent in November. That overall rate, also known as headline inflation, was lower in all but two of the 19 economies that used the euro in December.

These signs of slowing inflation will bring some relief to consumers — but won’t ease the concerns of central bankers tasked with getting inflation back to their 2 percent target. That’s because they are closely watching another measure of inflation that continues to climb.

That measure is called “core inflation,” and the uncertainty about where it is heading is “what keeps the European Central Bank up at night right now,” said Oliver Rakau, chief German economist at Oxford Economics.

There are many ways to measure inflation to determine how deeply higher prices are becoming embedded in an economy. Core inflation is one of the most common ones because it excludes food and energy prices, which are prone to volatility as they fluctuate alongside globally traded commodities markets.

And it can highlight domestic sources of inflation, such as higher prices in the services industry, which often rise when employers raise wages to attract workers in a tight labor market. It can serve as a warning signal for how long high prices may last, and encourage central bankers to keep raising interest rates.

In the eurozone, core inflation was 5.2 percent last month, unexpectedly rising from 5 percent in November. Services inflation rose to 4.4 percent in December, from 4.2 percent the previous month.

On Friday, data showed that core inflation in Spain rose to 7 percent in December, setting it above the broader headline inflation rate.

This divergence between headline and core inflation presents a conundrum for central bankers debating when to stop raising interest rates. The headline inflation rate is slipping, and is expected to fall quite sharply later this year when last year’s surge in energy prices falls out of the annual calculations. But core inflation, which can represent the lagging impact of those price rises, isn’t expected to fall as quickly.

After the most aggressive cycle of monetary policy tightening in the European Central Bank’s history, there are a range of opinions among policymakers — as there are at the Bank of England — about the severity of the risks ahead.

Those who feel it may soon be time to slow or halt the pace of interest rate increases argue that wage growth in the region has not gotten too strong, consumer expectations about inflation aren’t too high and the impact of rate increases in recent months is still to come and will help arrest inflation. On the other hand, high core inflation, the uncertainty about fiscal policy, potential wage growth and the inherent volatility of energy prices have made others reluctant to take their foot off the economic brakes yet.

Since July, the European Central Bank has raised rates by 2.5 percentage points. On Friday, economists at Fitch Ratings said they expected another 1.5 percentage point increase in the first half of this year because “the central bank has become much more concerned about core inflation pressures.”

Staff at the European Central Bank forecast core inflation to average 4.2 percent over all of 2023 and to still be elevated in 2025 at 2.4 percent.

High core inflation is not just a concern for European policymakers. In the United States, the headline rate of inflation has declined for six consecutive months, helped by a decline in gasoline and other prices, but the core inflation rate is more sticky, rising on a monthly basis in December, data published last Thursday showed. Inflation among service industries, driven by a strong labor market, means Federal Reserve policymakers are expected to keep raising interest rates but at a more modest pace. In fact, economists at the European Central Bank predict that underlying inflation will stay higher in the United States than in the eurozone in the near future.

But “Europe could be really be the focus of attention going forward,” said Daniel Tenengauzer, head of markets strategy at BNY Mellon. For one, he said, he expects that wage adjustments to higher inflation in Europe to go on for years. “That will cause a fairly high pressure” on core inflation, he added.

Policymakers and other economists are also alert to the risk that fiscal policies aimed at protecting households from the worst effects of soaring energy costs will also fuel inflation. If they are too broad-based and long-lasting, they could boost consumer demand. Other signs that the eurozone’s economy will fare better than expected, including its relatively strong labor market, add to the risks of persistent inflation and encourage the central bank to sound resolute in its plan for higher rates.

Last month, Christine Lagarde, the president of the European Central Bank, said that the governing council expected to raise interest rates “significantly further” because inflation was forecast to be above target for too long and that a recession, if it materialized, would be “relatively short-lived and shallow.”

There is a risk that the central bank will end up tightening policy too much as it errs on the side of caution, especially after underestimating inflation so much last year, Mr. Rakau said.

Eurozone policymakers “might be overdoing it but I don’t think they will be convinced of this very quickly,” he said. Rather than rely on inflation forecasts, they will want to see “the peak in core inflation coming in or the labor market slowing.”