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Euro zone inflation soars to new high, intensifying ECB dilemma

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© Reuters. FILE PHOTO: The European Central Bank (ECB) logo in Frankfurt, Germany, January 23, 2020. REUTERS/Ralph Orlowski/

FRANKFURT (Reuters) – Euro zone inflation soared to another record high last month, intensifying a policy dilemma for the European Central Bank, which must convey a sense of calm amid war-related market turmoil but also respond to mounting price pressures.

Inflation in the 19 countries sharing the euro accelerated to 5.8% from 5.1% in January, beating expectations for 5.4% and also confounding the ECB’s own projection for a drop, data from Eurostat showed on Wednesday.

A 32% jump in energy costs drove inflation last month but unprocessed food prices were also up sharply, rising 6.1% and making inflation especially painful for lower income families.

With energy prices soaring due to Russia’s war in Ukraine, inflation is all but certain to accelerate even further in the coming months, analysts say, and could average around 5% or more this year, more than twice the ECB’s 2% target.

As price pressures had been building for months, the ECB was all but certain to accelerate its exit from ultra easy policy at its March 10 meeting.

But the war has thrown those plans into turmoil, leaving the policy outlook uncertain.

The problem for the ECB is that, while war is likely to boost prices above all forecasts this year, it is a negative for both growth and inflation in the longer term, a horizon that is more relevant for the central bank.

High energy costs sap household purchasing power, eat into corporate margins and weigh on investment. They are also likely to impact the price of other goods and services, particularly food prices, as natural gas is the biggest cost in fertilizer production.

Meanwhile financing conditions have already tightened, mainly due to falling share prices, particularly a 25% drop in the euro zone bank index since mid-February.

ECB board member Fabio Panetta, an outspoken policy dove, has already made the case for holding off on any further policy tightening.

Graphic: Oil prices- https://fingfx.thomsonreuters.com/gfx/mkt/gkplgalzzvb/oilprices.JPG

ECB hawks meanwhile argue that inflation is already high and broad based, so maintaining extraordinary stimulus is unwarranted and a more neutral policy setting would be appropriate.

Bundesbank President Joachim Nagel said on Wednesday that, with German inflation likely to be higher this year than a recently raised forecast, the ECB should keep its focus on normalising policy.

Underlying inflation is also rising quickly, suggesting that it is no longer just volatile items that push up prices.

Inflation excluding food and energy prices accelerated to 2.9% in February from 2.4% the previous month and even narrower measure, which excludes alcohol and tobacco, rose to 2.7% from 2.3%.

Hawks also argue that ordinary people are increasingly feeling the pain of high inflation, so it is also politically risky for the central bank not to act.

Markets, which priced in 50 basis points of interest rate hikes this year just weeks ago, now only see around 15 basis points worth of increases. German 10-year yields, in positive territory in February, hit minus 0.41% on Wednesday as investors reprice the policy outlook.

The ECB will next meet on March 10 and the policy decision remains wide open and subject to developments in Ukraine.

Euro zone inflation soars to new high, intensifying ECB dilemma

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