The European Central Bank building
The surprise increase in inflation is likely to put pressure on the European Central Bank to reduce its monetary stimulus quicker than planned © AP

Eurozone inflation rose to 5 per cent in December, setting a fresh record high since the single currency was created more than two decades ago and raising doubts over how quickly price pressures will ease this year.

Driven by soaring energy and food prices, annual price growth in the euro area — as measured by the harmonised index of consumer prices — outstripped the expectations of economists polled by Reuters, who had on average predicted a 4.7 per cent rise, slightly down from 4.9 per cent in November.

The surprise increase is likely to put pressure on the European Central Bank to reduce its monetary stimulus quicker than planned. Although most economists expect inflation to begin to ebb from January onwards, it is forecast to remain above the ECB’s 2 per cent target for much of this year.

“This should be the peak, but headline inflation will stay elevated at least until late summer, especially as higher wholesale energy prices are passed through to retail consumers and other parts of the economy,” said Carsten Brzeski, head of global macro research at ING. “Several corporate clients have told us they will increase prices over the course of 2022.”

Line chart of Harmonised index of consumer prices (annual % change) showing Eurozone inflation: ending the year on a record high

Inflation has risen sharply in recent months as the eurozone economy rebounds from the shock of the pandemic, activity restrictions have been lifted and supply struggles to keep pace with demand, driving up energy costs and creating shortages of many materials.

Eurostat said prices were up 0.4 per cent from the previous month, driven by an acceleration of price rises for food, alcohol, tobacco and other goods. Energy prices rose 26 per cent from a year earlier, a slight slowdown from the previous month.

Excluding more volatile energy and food prices, core inflation was steady at 2.6 per cent.

Most economists expect eurozone inflation to start falling in the coming months as the effect of Germany’s pandemic-driven temporary cut in sales tax disappears from the data, energy prices stabilise and global supply chain bottlenecks ease.

However, European wholesale natural gas prices almost doubled to record highs in the run-up to Christmas and jumped again this week after supplies from Russia slowed. Supply chain bottlenecks continue to cause delays and higher costs for manufacturers, pushing up the price of many consumer goods.

“The fast pass-through of surging wholesale costs into retail utility bills in Spain, and to a lesser extent Italy, despite government intervention, was the key upside surprise for us in December,” said Jacob Nell, head of European economics at Morgan Stanley.

The ECB responded to mounting concern about rapidly rising prices last month by saying its €1.85tn pandemic-response bond buying scheme would stop net purchases in March as part of a “step-by-step” reduction of its quantitative easing policy.

The central bank also sharply raised its eurozone inflation forecast to 2.6 per cent for 2021 and 3.2 per cent for 2022, while predicting it would drop back below its 2 per cent target next year.

Philip Lane, ECB chief economist, said 5 per cent inflation sounds “so strange” after a long period of ultra-low price growth in the eurozone. But he told Irish broadcaster RTE, “we do think inflation pressures will ease over the course of this year” so the case for raising rates “is not there”.

Investors continue to bet that high inflation will force the ECB to start raising interest rates from deeply negative levels earlier than it expects. Money market futures are pricing in a 0.1 percentage point increase in the ECB’s deposit rate in October.

Jack Allen-Reynolds, senior Europe economist at Capital Economics, said eurozone inflation was likely to remain above 2 per cent “at least until the fourth quarter” and predicted that as a result the ECB would “begin to prepare the ground for tighter monetary policy in 2023”.

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