The Ecb Is Already Behind The Inflation Curve

On Thursday, June 11th, the European Central Bank announced an increase in its three policy-setting interest rates:

The Governing Council is committed to setting monetary policy to ensure that inflation stabilises at its 2% target in the medium term. In line with this commitment, it today decided to raise the three key ECB interest rates by 25 basis points. 

Hopefully, this is the beginning of a series of rate hikes by the ECB. 

It may seem harsh to wish higher interest rates on the European economy, where GDP growth is modest and large segments of it are trapped in perennial stagnation. However, Europe is facing the same threat of high inflation as the U.S. economy currently is. The actual inflation rates in consumer and producer prices may not turn out to be as high, but given that the European economy in large part is standing still already, even moderate inflation levels can do a lot of economic damage.

Higher interest rates can help rein in the negative fallout from inflation, even in a stagnant economy like the one most of Europe has to deal with today. More than dampening economic activity, higher rates prevent the private sector from using credit expansions to compensate households and businesses for inflation. 

In plain English: high interest rates make it unaffordable for people to go into debt as a way to compensate for inflation. 

Once that fallout has been dealt with—in other words, once the European economy has absorbed this inflation blow—it will be a good time to reduce interest rates again.

The ECB is rigid in its policymaking; the bank certainly does not rush to change its interest rates. It has been a year, almost to the day, since it reduced its policy rates by the same amount as the new rate hikes. This is good in general, as it renders more weight to each policy decision the bank makes.

At the same time, it also means that the ECB suffers from a non-trivial degree of inertia: it is slow to respond to changing circumstances. Last year’s rate cut was driven by concerns that the European economy was going to be unable to propel itself out of its state of long-term stagnation. Those concerns are no longer valid: for some time now, it has been clear that inflation is the most prevalent threat to the European economy.

Therefore, today’s decision by the ECB’s Governing Council to increase interest should have happened at its previous meeting, but it is nevertheless welcome:

In the baseline of the new Eurosystem staff projections, headline inflation is expected to average 3.0% in 2026, 2.3% in 2027 and 2.0% in 2028. 

It is almost a mathematical certainty that there will be more rate increases this year; the ECB’s forecast of 3% inflation for 2026 is overly optimistic. So far this year, the annual consumer price inflation in the euro zone has accelerated from 1.7% in January and 1.9% in February—both numbers essentially signs of price stability—to 2.6% in March, 3.0% in April, and 3.2% in May. This follows the trend of U.S. inflation in consumer prices, which reached 4.3% in May; it is likely that the euro zone will see inflation at 4% or higher before the end of the summer.

Producer prices play a big role in consumer-price inflation. If producer prices go up, it usually takes two months before consumer prices respond. This lag helps us predict where consumer prices are headed in the coming months, especially since producer prices are once again rising. 

On June 11th, the U.S. Bureau of Labor Statistics released producer-price index (PPI) figures for May: the annual inflation rate in the prices that producers pay for their input products is 13.1%. This high figure does not yet have an equivalent in Europe, although part of the reason for this is that Eurostat does not produce a fully comparable aggregate index for euro zone producer prices. 

The closest ‘industry’ index from Eurostat shows euro zone producer prices rising at 4.2% in April, roughly half the U.S. rate for that month. However, the numbers from individual EU members vary drastically: from -5.4% in Luxembourg to 15.2% in Bulgaria. Another three countries have producer price inflation above 10%: Lithuania at 13.2%; Greece at 12.9%; and Romania at 10.3%.

Although producer price inflation is not quite as much of a problem in Europe at this point as it is in America, that is very likely going to change. The European economy is suffering even more from an energy price shock than the U.S. economy is; that price shock is strong enough to make up for the fact that there is little demand-pull pressure on European prices. Bluntly, while economic growth is too weak to set inflation in motion, bad energy policies across Europe have made the continent formidably vulnerable to an oil price shock.

The United States produces enough oil to be self-sufficient, but the energy price shock has still made it onto American shores. Together with the higher long-term level of total spending in the U.S. economy, this will maintain high pressure on producer prices on both sides of the Atlantic. 

With all this in mind, the ECB’s forecast of 3.0% inflation for 2026 comes across as modest, even irresponsibly modest. If this is indeed their benchmark, we can definitely expect more rate hikes throughout the year.