European Inflation Slows as Warm Winter Condition Persist

Despite declining inflation rates being excellent news for consumers, central bankers continue to be watchful against the factors that cause inflation. A worsening of the situation is possible if cold weather sets in (there is still a long winter ahead) and there is an assault on a fragile European energy infrastructure.

After skyrocketing for most of last year and sending inflation rates to historic highs, which wreaked havoc on the region's economy, the recent string of unseasonably mild and even warm weather has helped bring natural gas prices back down. As energy prices have fallen from their painful highs, inflation in Europe has slowed for the first time in over a year. However, the region's double-digit rate of inflation continues to linger around a record high, which has sapped consumer confidence and caused experts to forecast a recession.

Much of the pressure released when Russia invaded its neighbor about a year ago has dissipated due to milder weather, more diverse supply, and measures to minimize usage. Recently, gas prices have dropped to levels not seen since before the start of World War II, and the number of gas barrels in storage is much larger than the average for the last five years.

However, much of winter still remains, and there are still potential dangers from harsh weather or delays in fresh food supplies. An upcoming cold spell is predicted for the area.

According to senior economist Joerg Angele of Bantleon in Zurich, there is a potential that headline inflation may achieve the European Central Bank's (ECB) 2% objective in the fourth quarter rather than in 2025, as the institution anticipated only a month ago. Maintaining current gas prices will "put tremendous pressure on inflation," he said. Assumptions made by the ECB in December were much higher than current market levels, suggesting that the bank may alter its next set of predictions downward to reflect reality.

According to Eurostat, the European Union's statistical office, consumer prices in the 19 nations using the euro currency rose by 10% year-over-year in November. That's the first monthly decline since June 2021, followed by a 10.6% loss in October. The figure represented stronger yearly price increases for food, alcohol, and cigarettes at 13.6%, while energy price increases slowed to 34.9% from a sky-high 41.5% in October.

Russia's widespread severance of natural gas supplies due to the conflict in Ukraine, supply bottlenecks due to the surge in demand after lifting COVID-19 limitations, and the resulting high energy prices all contribute to out-of-control inflation.

Although consumers will welcome these developments, central bankers entrusted with bringing inflation back to their 2 percent goal remain unnerved because they are keeping a close eye on another inflation indicator that keeps going up.

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Inflation may be measured in several ways to ascertain the extent to which rising prices are becoming permanent fixtures in a given economy. One of the most popular measures of inflation, "core" inflation strips out volatile categories like food and energy costs that move in tandem with internationally traded commodities.

Additionally, it may provide insight into domestic drivers of inflation, such as increases in the cost of services due to tight labor markets and subsequent pay increases by businesses. It can act as an early warning system for how long high prices could last, encouraging central banks to maintain their interest rate hikes.

The core inflation rate in the Eurozone increased to 5.2% in December from 5% in November. Compared to November, when services inflation was at 4.2 percent, December saw an increase to 4.4 percent.

According to figures released on Friday, core inflation in Spain hit 7% in December, exceeding the wider headline inflation rate.

For central bankers contemplating whether to stop increasing interest rates, the discrepancy between headline and core inflation offers a problem. When last year's dramatic increase in energy costs is removed from yearly calculations, the headline inflation rate is projected to decline dramatically later this year. On the other hand, core inflation—which may be seen as the lagged effect of these price increases—is not anticipated to reduce as rapidly.

Similarly to the Bank of England, European officials are split on the severity of the dangers ahead after the most aggressive round of monetary policy tightening in the institution's history.

Wage growth in the region has not gotten too strong, consumer expectations about inflation are not too high, and the impact of rate increases in recent months is still to come and will help arrest inflation, according to those who feel it may soon be time to slow or halt the pace of interest rate increases. Others, however, are hesitant to release the brakes on the economy just yet due to high core inflation, uncertainty about fiscal policy, possible wage increases, and the inherent volatility of oil costs.

The European Central Bank has increased interest rates by 2.5 percentage points since July. "the central bank has grown considerably more worried about core inflation pressures," Fitch Ratings analysts said on Friday, explaining why they anticipate another 1.5 percentage point rise in the first half of this year.

The European Central Bank expects core inflation of 4.2% for 2023 and 2.4% for the full year of 2025.

The high core inflation rate is a problem for more than just European policymakers. The headline inflation rate in the United States has been falling for six months in a row, and a decline has helped in the price of gasoline and other goods and services. However, the core inflation rate is more persistent, and it rose monthly in December, according to data published last Thursday. It is anticipated that officials at the Federal Reserve will continue to raise interest rates, although at a more measured pace, as a result of service sector inflation, which is being driven by a robust labor market. In point of fact, economists working for the European Central Bank anticipate that underlying inflation will continue to be higher in the United States than it will be in the Eurozone in the not-too-distant future.

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Inflation is a concern for policymakers and other economists, and they are aware of the possibility that fiscal measures designed to shield people from the most detrimental consequences of rising energy prices might also contribute to its acceleration. They could increase consumer demand if they are excessively pervasive and continue for an extended period of time. Other indications that the economy of the Eurozone would perform better than anticipated, such as its rather robust labor market, contribute to the dangers of ongoing inflation and urge the European Central Bank to maintain a firm stance regarding its intention to raise interest rates.

There are also fears that Europe might be in for an even more difficult year ahead as it fights to restore the gas supplies that Russia previously supplied, while China's rapid reopening of the Covid pipeline could increase the demand for liquefied natural gas.

Economists are becoming more optimistic as a result of the improvement in the energy situation. Last Monday, Goldman Sachs and Bank revised their forecasts, indicating that they no longer believe the Eurozone would experience a winter recession. Instead, they believe that reduced gas prices will probably hasten the decline in inflation.

The figures released on Friday (January 13) showed that Germany's economy most likely averted a decline in the last three months of 2022, which provided support for such views.

Others, on the other hand, are warning that much more suffering is still to come. Bantleon's Angele says that many households, such as renters in Germany, will still be faced with eye-watering high heating bills this year. While there is a fairly direct link between wholesale gas prices and what consumers pay in countries like Italy and the Netherlands, Angele says that many households will still face the possibility of horrific high heating bills this year.

Meanwhile, finance ministers throughout the region may be able to exhale a sigh of relief because the many assistance measures they agreed on the previous year seem cheaper than was expected. The prediction for the budget deficit in the Eurozone in 2023 that the economists provided at Berenberg has already been revised downward, moving from 4.3 percent to 3.7 percent.

All of this will not significantly impact the decision-makers at the ECB since, as of late, they have been emphasizing the importance of their focus on underlying inflation, which excludes volatile components such as energy and food prices.

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                       European natural gas prices drop back to pre-Ukraine war levels | DW News