Sluggish economic growth and high inflation leave European Central Bank in tight spot

The euro zone economy is barely growing but inflation in the bloc remains high, leaving the European Central Bank with little choice but to inflict more financial pain on households and businesses to tame prices.

Buffeted for more than a year by the surge in fuel prices that followed Russia’s invasion of Ukraine, people in the 20 countries that share the euro are now starting to feel the effects of the ECB’s massive increase in borrowing costs.

Economic output in the euro zone increased by just 0.1 per cent in the first three months of the year as domestic consumption stagnated in many economies, a sign that surging inflation and falling real incomes are taking their toll on consumers.

Growth came mostly from exports, the result of a revival in global trade as China reopened for business after the pandemic.

But national data showed price growth remained stubbornly high, probably leaving the ECB with no choice but to keep raising interest rates.

“Individual country inflation data keeps pressure on the European Central Bank to remain aggressive on the hiking front at next week’s central bank meeting despite euro-wide growth not that far from flatlining,” said Charles Hepworth, an investment director at asset manager GAM Investments.

The ECB is widely expected to raise rates for the seventh straight meeting on May 4, with policy-makers weighing another half-percentage-point (50 basis points) hike against the merits of slowing rises down to a quarter-point.

Friday’s inflation data showed progress was slow.

A slight decline in inflation in large German states pointed to a likely drop when countrywide figures are published at 1200 GMT. Portugal and Ireland saw a sharp drop in price growth, too.

Headline inflation rose in France and Spain, however, largely as a result of some energy subsidies being reduced or phased out. But in a potential glimpse of sun for the ECB, there were some signs food prices are easing in both countries.

Surging grocery bills have been a key driver of overall inflation across the euro zone in recent months, driven by higher fuel costs, unfavourable weather and some margin expansion by companies.

Money markets currently price in another 70 basis points of ECB rate hikes by October, possibly followed by cuts as early as the start of next year.

The International Monetary Fund challenged those expectations on Friday, calling on the ECB to keep raising interest rates until the middle of 2024.

It also said European Union finance ministers should tighten fiscal policy in concerted action to bring down high inflation, which would probably depress consumption further.

But economists said rate increases by the ECB and other central banks since last year were already likely to curb economic growth in the coming months, and might even push the euro zone into recession.

“In the second half of the year the massive rate hikes by central banks worldwide are likely to apply the brake on growth,” Commerzbank’s senior economist Christoph Weil said.

The euro zone’s largest economy, Germany, was already stagnating as a decline in government and household consumption offset an increase in exports and capital investment.

Southern European economies Italy, Spain and, to a lesser extent, Portugal were the standout beneficiaries of a boost in trade, growing by 0.3 per cent-0.5 per cent in January to March compared with the last three months of 2022.

“All the (Spanish) growth comes from the foreign sector given a huge rebound in exports,” Angel Talavera, an economist at Oxford Economics, said.