Since July 2022 the European Central Bank (ECB), among other major central banks, has been strongly raising the interest rate to combat the surging inflation which ensued following the reopening of the global economy in the aftermath of the COVID pandemic. The ECB went on to raise the interest rate to 4,50% by September 2023, including two consecutive 0,75 percentage point hikes in late 2022 when inflation peaked at 10,7%, an unprecedented aggressive move. Luckily at that point inflation curved downward and steadily eased again.

Since February this year it has been ranging in the 2,4% to 2,6% range – fairly close to the ECB’s target rate of 2%, leading the ECB to implement the first interest rate cut in June, lowering it by a modest 0,25 percentage points as the Eurozone was teetering on the edge of a recession. However inflation is still somewhat too elevated to further cut down the interest rate, especially when considering core inflation, which excludes food and energy and is a more closely followed indicator as it removes seasonal price fluctuations of those two components. Core inflation still stands at 2,9% (as of June) and is particularly sticky.

But why is core inflation higher and why is it so sticky? Inflation consists of four main components: food (19,5% weight), energy (9,9% weight), non-energy industrial goods (25,7% weight) and the last and largest component is services (44,9% weight). The services component is the one that mainly drives both inflation and core inflation, not only because of its weight, but also because it grew the most of all components in terms of pricing, namely by 4,1% year-over-year as of June 2024. The energy component only grew by 0,2%, the food component by 2,4% and non-energy industrial goods component by 0,7%, holding down the overall inflation number to 2,5%. However, as the core inflation number excludes both food and energy components and therefore attributes an even larger weight (63,5%) to services, you end up with the higher core inflation number at 2,9%.

The reason why the services component grew by 4,1% and will only gradually slow down (and therefore the reason why inflation is so sticky) is simple: wages. In the services industry the human labor cost is proportionally much larger than in the other components where also the cost of various materials and goods represent a significant role. These costs are of course carried over in the prices of the goods and services consumers buy. Prices of materials and goods can drop significantly due to supply and demand mechanics and have a quick impact on pricing of food, energy, or industrial products and therefore inflation. But wages don’t ease so easily, especially in an inflationary environment.

In the first quarter of 2024 the Eurozone Labor Cost index stood at 5,1% year-on-year, meaning wages grew faster than inflation, i.e. purchase power increased. This is still an after-effect from the post-COVID reopening of the global economy when severe labor shortage and soaring inflation resulted in companies competing for workers by offering significantly higher wages. The labor market is still quite tight to this day, but should gradually begin to soften up, which in turn should cool down wage growth and then push inflation lower, but it’s a long slow process. It’s also the reason the ECB isn’t in a hurry to implement further interest rate cuts. There’s no need for them at this time.

The higher wages allow people to keep pouring money into the economy through consumption and it is a key reason that the Eurozone has narrowly avoided sinking into a recession so far. From the beginning of this year Eurozone retail sales have essentially been flat, with the latest reading (for May) coming in at 0,3% growth year-over-year. Mind you, this is adjusted for inflation, so in actuality consumers spent around 2,8% more in actual money terms, and still have extra money left to spare.

Money needs to work as it drives economic growth and investment returns. Over the past 3 years since the COVID lockdowns ended prices have increased by approximately 17,5% cumulatively. If money would be kept on a bank account during that period, it would allow you to only buy roughly 80% of what you could have bought with that same money 3 years ago. As a fund management company, we don’t mind that banks are barely paying any interest on deposits – it entices people to place their money in better yielding alternatives such as our funds – we don’t let the money sleep.

Rudy Marchant, vodja službe za upravljanje naložb