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Return of inflation IW News 2. March 2017

Early countermeasures required

Inflation is back in the Eurozone: Eurostat's flash estimate of annual inflation was 2.0 percent in February. This increase is not only due to hiking energy prices, but also to an increase in the core inflation rate. The ECB should therefore counteract its monetary policy.

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Next week, the ECB’s Governing Council will meet and decide on further measures - but perhaps not to curb inflation. However, the economic data indicates an increase in demand which will lead to higher inflation. For example, lending to companies has grown steadily in the last two years, rising by 1.7 percent year-on-year in January 2017. The unemployment rate in the Eurozone has shown a falling trend for two years and the economic growth rate of the Eurozone is currently at its pre-crisis average. In addition, the oil prices - which are leading the energy prices - have clearly increased. Energy costs are therefore expected to continue to grow. Overall, therefore, the ECB should correct its expansive monetary policy.

So far, however, the ECB has been very cautious: at its last Governing Council meeting, the central bankers decided to reduce their bond purchases, but to maintain their large scale. By the end of the year, monthly purchases worth 60 billion Euros will be made. The central bankers saw no reason for ending the purchase programs: they consider the increase in the core inflation rate, which excludes energy prices, to be too low.

But this view is a surprise because, as the deflation risks in the Eurozone materialised at the end of 2014, the core inflation rate still stood at 0.7 per cent. The concern of deflation was then based on the fall in energy prices, which can trigger a fall in the other prices with a time lag. Since the start of the public sector bond purchases in March 2015, however, the core inflation rate has risen from 0.6 percent to 0.9 percent. Now it should be the ECB's concern that the increase in energy prices, e.g. in January 2017 by 8 percent, will affect other prices with a time lag.

The ECB should now counteract and raise interest rates cautiously before the rising inflation requires large interest rate increases.

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