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War in Ukraine Drives Up Prices in Europe

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Photo: Christine Lagarde attempts to balance the risk of a return to high inflation with the risk of renewed economic slowdown. Source: ECB
Photo: Christine Lagarde attempts to balance the risk of a return to high inflation with the risk of renewed economic slowdown. Source: ECB

Inflation in the eurozone in May 2024 is not just about prices; it also ties into the upcoming European Parliament elections and the actions of the European Central Bank (ECB), whose interest rates impact the cost of credit and much more. What is currently driving inflation rates? The war in Ukraine is a primary factor, along with the lingering effects of the COVID-19 pandemic, which had driven prices up over the past three years. Workers have not forgotten the sharp price increases in previous years and are demanding higher wages. However, there is some good news: the situation with energy prices, from electricity to oil, has significantly improved.


According to a preliminary estimate by Eurostat, the statistical office of the European Union, annual inflation in the eurozone was 2.6% in May 2024, compared to 2.4% in April. What contributed most to the acceleration of price increases and the exceeding of the May inflation forecast, which was 2.5% annually?


The largest contributor to the acceleration of inflation was the rise in service prices, which increased by 4.1% annually in the eurozone, compared to 3.7% in April. There was also an impact from the rising prices of food, alcohol, and tobacco (2.6%), compared to 2.8% in April. Conversely, a slowdown in prices in some other categories prevented inflation from accelerating even more. For example, non-energy industrial goods increased by only 0.8% annually, compared to 0.9% in April, and energy prices rose by only 0.3%, whereas in April they had even decreased by 0.6% annually.

Photo: What and how prices are rising in the eurozone. Source: Eurostat


What is happening? Why are prices for services and everyday goods rising so much? This is a consequence of previous waves of inflation. Now workers are demanding higher wages to compensate for years of high inflation, which was triggered by two main factors: the aftermath of the pandemic and the disruption of supply chains due to Russian aggression in Ukraine.


The previous wave of inflation peaked in mid-2022, reaching a staggering 10.6% annually in October. High wage expectations now are a reflection of the period of rapid price increases.


To combat inflation, the ECB has raised interest rates. Overall, this increase amounted to 450 basis points from July 2022 to September 2023. This contributed to reducing the overall inflation rate in the eurozone from 10.6% to 2.6% in May 2024. Although this is not yet the ECB's inflation target of 2% annually, it is sufficient for some easing, it seems.


Moreover, good economic performance and a decrease in unemployment allow for a fairly optimistic outlook. Notably, the unemployment rate in the eurozone reached a record low at the end of May 2024. In the first quarter of 2024, the eurozone economy grew by 0.3% after the third and fourth quarters of 2023 saw contractions of 0.1%. Previously, in the second quarter of 2023, the economy grew by only a symbolic 0.1%, and in the two preceding quarters, there was stagnation.


Time to Ease Rates

Back in March 2024, ECB President Christine Lagarde signalled to Europeans that the period of high interest rates was coming to an end. She indicated that by June, the situation would be clearer to begin lowering the unusually high interest rates for the eurozone. It appears that the ECB has enough confidence that the trend of declining inflation will continue even after reducing rates, despite inflation exceeding previous expectations in May.


In March, the ECB released its most recent forecasts, which predict that the average inflation rate will decrease to 2% in 2025 and 1.9% in 2026.


Therefore, it was fully anticipated in early June that at its meeting on 6 June, the European Central Bank would lower interest rates by 25 basis points, reducing the main refinancing rate to 4.25%, the marginal lending rate to 4.50%, and the deposit rate to 3.75%.


This would be the first reduction in the main refinancing and marginal lending rates since March 2016. For the deposit rate, it would be the first cut since September 2019.


Why have ECB officials been so proactive in signalling a 25 basis point rate cut ahead of their meeting? Why are they willing to proceed with this despite the localised acceleration of inflation in May? They aim to bolster economic recovery. The previous high interest rates had slowed EU economic growth, which was the price paid to curb price pressures. Even after the ECB cuts its key rates, they will still be approximately 1.5 times higher than the current inflation rate, which should be sufficient to continue restraining prices.


However, there was no certainty about further rate cuts in July 2024 as of early June.


What are the possible consequences of this reduction? A too-rapid reduction in ECB interest rates, while the US Federal Reserve maintains higher rates, could weaken the euro relative to the dollar. This, in turn, could increase the risk of higher inflation rates due to rising prices of imported goods and services. Conversely, maintaining high ECB interest rates for too long could disrupt the beginning of the EU’s economic recovery following the challenges posed by the COVID-19 pandemic. Lagarde's intentions are a compromise between these two extremes.


PS: The ECB announced a few minutes ago about the expected reduction in interest rates..

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