European zone inflation may have peaked but is expected to ease slowly where it may take years before it returns to the European Central Bank's 2% target, keeping pressure on the ECB to tighten policy until 2023.
Having raised interest rates by a record 200 basis points since July, the ECB has already taken a big step towards taming inflation which hit 10.6% in October before easing last month to 10.0% – still five times the target level.
The pressure that occurs in the pipeline still remains a lot. In addition, energy prices are still sky high, unemployment is at a record low, and wage growth is accelerating. . The government's stimulus measures acted against the ECB's policy tightening, and too much of the rise in energy prices has spilled over into the wider economy through a second-round effect, driving underlying price growth.
Meanwhile, the recession that is expected to reduce inflationary pressure is now seen to be milder than feared.
All this suggests that inflation will slow down from its peak in the early months of 2023. Core inflation data will continue to be watched by some ECB policy makers rather than the headline numbers, remaining high.
"Core inflation is unlikely to peak until mid-2023 and will only fall slowly thereafter," said Commerzbank economist Christoph Weil. "Based on this background, the ECB's goal of pushing the inflation rate back to just below 2% on a sustainable basis is seen as a long way to go".
If disinflation proves too slow, firms and consumers may lose confidence in the ECB's commitment and adjust their wage and price setting behavior to reflect higher inflation, sustaining rapid price growth.
Although that has not happened yet, long-term inflation expectations are still high and continuing to rise. The key market-based indicator, often cited by the ECB, is now at 2.4%, well above the 2% target, and has risen despite policy tightening.
The ECB's new projections, to be released next week, are set to show inflation above target until 2024 and falling to just 2% in 2025.
Speaking of recession, recession is expected to ease price pressure but the decline may be more benign than feared. The supply crunch, which drives inflation as the economy emerges from the Covid-19 outbreak, is seen to be diminishing.
Additionally, pipeline pressures indicate that the ECB's move is far from over with rate hikes and its 1.5% deposit rate could still double before its job is done.
