FRANKFURT, Feb 16 (Reuters) - A year ago the European Central Bank struggled to explain why it was not lifting interest rates even as inflation rose. This year it will have a similarly tough job explaining why it keeps hiking them even as price growth falls quickly.
Inflation, already two percentage points below its peak, will fall rapidly through the spring as energy prices drop, and the bank will cut its own projections next month on lower gas prices and a rebound in the value of the euro.
Yet, the ECB has already promised another large rate hike in March and policymakers are also hinting at a move in May, pushing up mortgage costs, thwarting corporate investment and raising governments' debt burden just as consumers feel their first price relief in a year.
The problem is that the inflation outlook is not as good as it first appears.
Underlying price pressures show few signs of abating and even if the broader public knows little about core inflation -- which filters out volatile food and fuel prices -- policymakers are focusing on this figure because it is an indicator of the durability of price growth.
"We'll keep rates high until we see robust evidence that underlying inflation returns to our target in a timely and durable manner," ECB board member Isabel Schnabel said recently, repeating the bank's recent mantra about core inflation.
At some point over the summer, overall inflation, now at 8.5%, could fall below the core rate and could even drop below 3% by the end of the year as energy costs fall below pre-war levels and become deflationary. But core inflation is proving stubborn and could still rise from last month's 5.2%.
"We have to continue to emphasize that we have this medium term perspective," Klaas Knot, the Dutch central bank chief said. "And taking a medium term perspective means that of course underlying inflation is relevant for policy."
The issue is not unique to the euro zone. U.S. Federal Reserve officials also see headline inflation falling below core this year, and are particularly concerned that rising prices for services could make it more difficult to return inflation to their 2% target.
But communicating this to the public is difficult. The ECB is supposed to target headline inflation at 2% and it is already under fire from investors for sending mixed messages.
It has oscillated between focusing on current inflation, future inflation and core inflation. It has also moved between providing policy guidance and applying a meeting-by-meeting approach.
Still, its core inflation problem is why Irish central bank chief Gabriel Makhlouf, a moderate on the rate-setting Governing Council, recently said that the ECB's 2.5% deposit rate could even exceed 3.5%, rising above the market's current pricing of the peak rate.
If inflation does indeed become as stubborn as some fear, the ECB faces the problem of a "high sacrifice ratio," Croatian central bank chief Boris Vujcic warns. In such a situation, the economic loss associated with lowering inflation rises and the pain associated with each increment goes up.
COMPLICATIONS
Core inflation is likely to fall, but could still remain at a high level.
The big issue is the labour market.
Even as businesses prepared for an almost certain recession, they kept hiring at a brisk pace and pushed employment to a record high last quarter, hoarding labour after struggling to hire back workers in the post-pandemic months.
This will pressure wages, which are already seen rising by more than 5% this year, the fastest pace in years.
"Workers’ pressures to regain lost purchasing power might be significant, especially since upcoming wage negotiations will take place in a context of a tight labour market," Spanish central bank chief Pablo Hernandez de Cos said.
Given high inflation, real wages will still fall this year but unions are now increasingly focusing on past price hikes when making wage demands and such a backward looking wage setting mechanism could easily perpetuate high inflation.
Another problem is in services. Wages are the biggest factor in that sector's prices and services inflation is still just above 4%. So wage growth of the magnitude of 5% or more could push services inflation even higher.
Furthermore, the weight of services in the inflation basket rose to 44% this year from 42% as post-pandemic consumer habits change, so quicker inflation there gives an even bigger boost to core figures.
But some analysts think ECB fears over core prices are overdone.
"It’s just a natural re-juggling of the consumption pattern back to where we came from," UniCredit economic advisor Erik Nielsen said.
"As it puts extra stress on specific 'high visibility' sectors, including airlines, hotels and restaurants, many casual observers mistake the price pressure in these specific sectors for general overheating in the economy."
