European Inflation Falls to 2.2% in August

Inflation in Germany took a significant dip in August, falling to 1.9% compared with the same month last year. This marks the lowest rate in more than three years and surpasses many economists’ expectations. Preliminary figures from the Federal Statistical Office revealed this information on Thursday.

Consumers in Germany experienced some relief from economic pressure as the inflation rate in August dipped. This is the lowest level recorded in more than three years, bringing inflation below the European Central Bank’s (ECB) 2% inflation target for the eurozone. The new data could support the case for another interest rate cut by the ECB next month.

“People have more money in their wallets again. Inflation is falling, real wages are rising for the fifth quarter in a row,” Chancellor Olaf Scholz commented on X, formerly known as Twitter. The primary factor behind the inflation reduction was a significant decrease in energy prices.

Although food prices were 1.5% higher than in August last year, this rise was less substantial compared to previous months. Prices for services saw a notable increase, rising by 3.9% in a year-on-year comparison. Eurozone inflation had previously exceeded 10% in October 2022 due to rising energy prices following Russia’s invasion of Ukraine.

The reduction in inflation offers a positive outlook for German consumers and raises expectations for potential ECB monetary policy adjustments in the near future. Euro zone inflation dropped to a three-year low of 2.2% in August, according to flash figures from statistics agency Eurostat released Friday. This decline supports expectations for a September rate cut from the European Central Bank (ECB).

The core rate, which excludes volatile components such as energy, food, alcohol, and tobacco, fell to 2.8% in August from 2.9% in July, matching a Reuters poll. Economists polled by Reuters had anticipated the overall drop from 2.6% in July, aligning with the latest figures. Given these inflation statistics, markets are fully pricing in for the ECB to lower interest rates by another 25 basis points in September, following a similar rate cut in June.

Another 25 basis point cut is anticipated before the end of the year. In response to the data, the euro continued to slide against sterling, trading 0.1% lower at 0.8408 pounds. However, it nudged 0.04% higher against the U.S. dollar to $1.1083 as investors brace for a possible September rate cut from the Federal Reserve.

Despite the positive headline, there are underlying concerns. Kyle Chapman, a foreign exchange markets analyst at Ballinger Group, pointed out that services inflation remains at 4.2%. “The positive headline is purely down to energy price effects, and it masks the fact that little real progress in underlying pressures has been made here,” Chapman said.

“Services inflation has been glued to the 4% area for almost a year now and has headed in the wrong direction since the spring.”

Economists at ING expect euro zone core inflation to remain stubbornly above 2.5% for the remainder of the year due to persistent price pressures in goods and services.

Headline inflation sees significant drop

Ed Smith, co-chief investment officer at Rathbones Asset Management, commented that the central bank is on track for further rate cuts.

He emphasized ECB President Christine Lagarde’s focus on wage inflation. “Negotiated wages are a big thing in the euro zone. They account for about 80% of the workforce who have wage growth negotiated for them,” Smith said, noting a substantial drop in euro zone-wide negotiated wages in the second quarter.

Smith added, “However, there is some stickiness; the latest purchasing managers’ index numbers and service sector surveys showed some persistence in price components, which will keep some ECB voting members cautious.”

With inflation figures influencing monetary policy, the ECB’s upcoming decisions will significantly impact the economic landscape across the Euro zone. Inflation in the 20 European Union countries that use the euro fell sharply to 2.2% in August, opening the door for the European Central Bank (ECB) to cut interest rates. The ECB and the U.S. Federal Reserve are preparing to lower borrowing costs to support growth and jobs.

The August figure was down from 2.6% in July, according to Eurostat, the European Union statistics agency. Energy prices fell by 3% in August, helping lower the overall figure. Inflation fell to 2% in Germany, the eurozone’s largest economy.

The current rate is now close to the ECB’s target of 2%, which is considered optimal for the economy. The central bank aims to maintain stable prices under the European Union’s founding treaty. Not all of the EU’s 27 countries use the euro.

Economists expect the ECB to cut its key rate by a quarter point from 3.75% at its meeting on September 12, while the U.S. Federal Reserve is expected to cut rates from a 23-year high of 5.25%-5.5% at its policy meeting on September 17-18. The lower German inflation figure “tilts the balance toward a September rate cut,” said Carsten Brzeski, global chief of macro at ING bank. “Fading inflationary pressure combined with fading growth momentum offer an almost perfect macro backdrop for another rate cut.”

Economists caution that the path downward to 2% may still be bumpy.

The ECB has said it expects inflation to fluctuate but to fall to its target by the end of next year. Central banks sharply raised interest rates to counter an outburst of inflation caused by a spike in energy prices following Russia’s invasion of Ukraine and by clogged supply chains for parts and raw materials as the global economy rebounded from the COVID-19 pandemic. Higher rates can quell inflation by making it more expensive to borrow and buy things, reducing demand for goods and thus taking pressure off prices.

Europe’s inflation has now fallen significantly from the 10.6% it reached in October 2022. However, higher rates can weigh on growth, and those concerns have come to the fore in both Europe and the U.S. While unemployment rates remain low in both economies, central bankers are becoming wary of keeping rates too high for too long, which could lead to job losses or a recession. The eurozone grew only a modest 0.3% in the second quarter.

High rates have curtailed a years-long rally in European house prices and dampened loans to consumers and businesses, while complicating financing decisions for new renewable energy projects that are highly rate-sensitive. Rates that “are too high for too long” could fail to minimize the side effects on economic activity and jobs, which in turn could lead to “chronically below-target inflation,” Philip Lane, a member of the ECB’s executive board, said at a Federal Reserve conference in Jackson Hole, Wyoming. Lane kept the ECB’s options open for September, stating that a return to the 2% target “is not yet secure.”

ECB head Christine Lagarde has said the bank will make rate decisions on a meeting-by-meeting basis, based on incoming economic data.

The ECB made a first rate cut in June, paused in July, and has since been waiting for clear signals to make further cuts.