ECB Faces Tough Decision as Euro-Zone Inflation Remains High

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The European Central Bank (ECB) is facing a difficult dilemma as it prepares for its next policy meeting on September 14th. The latest data showed that euro-zone inflation did not slow down as expected in August, raising concerns about whether the central bank should continue raising interest rates or pause its tightening cycle.

Inflation Stuck at 5.3% in August

According to Eurostat, consumer prices in the euro area rose by 5.3% year-on-year in August, unchanged from July and above the median forecast of 5.1%. This was mainly driven by energy prices, which surged by 23.1% over the same period.

ECB Faces Tough Decision as Euro-Zone Inflation Remains High
ECB Faces Tough Decision as Euro-Zone Inflation Remains High

The inflation rate remained more than two and a half times above the ECB’s target of close to but below 2%, putting pressure on policymakers to act swiftly to bring it back under control.

However, core inflation, which excludes volatile items such as food and energy, also slowed down slightly to 5.3% in August from 5.4% in July. This suggests that some of the inflationary pressures may be transitory and related to supply bottlenecks and reopening effects.

ECB Officials Divided on Next Steps

The mixed inflation picture has created a split among ECB officials on how to proceed with monetary policy. Some of them have signaled a preference for another quarter-point hike in the deposit rate, which is currently at a record low of -3.75%. Others have argued that the central bank should wait for more evidence of the inflation outlook and the impact of its previous rate increases.

ECB Executive Board member Isabel Schnabel said on Thursday that the policy stance should be consistent with a timely return of inflation to the 2% target. She added that if the pace of disinflation is proceeding as desired, the ECB may afford to wait until its next meeting to gather more evidence.

ECB President Christine Lagarde has avoided giving a clear indication of her intentions, while some of her more hawkish colleagues have expressed their concerns about inflation. Germany’s Joachim Nagel said last week that he was not convinced that inflation was under control, while Latvia’s Martins Kazaks said it was better to err on the side of tighter policy. Austria’s Robert Holzmann also hinted that he may push for a hike.

Economic Outlook Worsens amid Delta Variant

The ECB’s decision will also depend on the economic outlook, which has worsened in recent weeks due to the spread of the delta variant of the coronavirus. The latest survey of purchasing managers showed that the euro-zone manufacturing sector contracted for the second month in a row in August, while the services sector also shrank for the first time this year.

Confidence among consumers and businesses has also deteriorated, raising doubts about the strength of the recovery. The ECB’s own staff projections, which will be updated next week, are likely to show a downward revision of growth and an upward revision of inflation for this year and next.

The ECB faces a tough trade-off between containing inflation and supporting growth. If it decides to hike rates again, it may risk choking off the recovery and hurting the most vulnerable countries in the euro zone. If it decides to pause, it may risk losing credibility and letting inflation expectations become unanchored.

The ECB will announce its policy decision on September 14th at 13:45 CET, followed by a press conference by Lagarde at 14:30 CET.

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