By Ed Frankl


Higher energy costs and a pickup in services prices drove inflation in the eurozone further beyond the European Central Bank's target in May, cementing expectations that policymakers will raise the key interest rate next week.

Ahead of the first U.S. and Israeli strikes on Iran at the end of February, inflation in the 21-nation currency area had been close to the ECB's 2% target for around a year, falling below the threshold to 1.7% in January. The central bank's President Christine Lagarde had repeatedly said monetary policy was in a "good place."

But the conflict and the impact of the closure of the Strait of Hormuz led to a surge in global oil and natural-gas prices, with the eurozone particularly exposed as a net importer of energy.

Eurozone inflation rose to 3.2% in May, a fourth-straight increase and the highest level since September 2023, statistics agency Eurostat said Tuesday, up from 3.0% in April. A consensus of economists polled by The Wall Street Journal also expected 3.2% inflation. Energy costs were 10.9% higher than the same month a year ago, marginally stronger than the 10.8% rise recorded in April, the data showed.

Before the war, investors had expected the ECB to leave borrowing costs unchanged this year. Now, they expect the bank to raise its key rate to 2.25% from 2% on June 11, the first increase in almost three years. Investors then anticipate between one and two further quarter-point hikes by the end of this year, LSEG data shows.

ECB executive board member Isabel Schnabel at a conference in Korea on Monday signaled that she would vote for a hike next week.

"We can no longer look through this shock," she said.

In one concerning data point, the share of firms intending to raise prices in the next three months has increased at a faster pace than in the aftermath of Russia's full-scale invasion of Ukraine, according to a recent European Commission survey.

"The risk of de-anchoring inflation expectations is rising," she added.

Services inflation rose to 3.5% in May from 3.0% in April, Eurostat said. Meanwhile, a survey of purchasing managers published Monday showed manufacturers' input costs rose at their steepest pace since May 2022, while the prices they in turn charged their customers rose at the fastest pace in three-and-a-half-years.

Those figures might concern central bankers given that rising prices could lead to increased wage demands, raising costs for firms and reinforcing higher and higher prices.

The increase in services and core inflation--the measure which strips out more volatile energy and food costs--is possibly an early sign of the indirect effects of high oil prices, Commerzbank senior economist Vincent Stamer said in a note to clients.

"Barring a significant change in the situation in the Persian Gulf, inflation is now likely to remain around the 3% mark," he said.

Nevertheless, May's level of inflation is trending closer to the ECB's more benign forecast for the inflationary hit from the war. In March, it said it expected inflation at 3.1% in the second quarter of the year under a baseline scenario, but at 3.6% in an adverse scenario and at 4.4% in a more severe one.

Indeed, ECB policymakers might remain cautious of the link between rising energy costs and more underlying inflationary pressures, especially given that interest-rate increases could crimp already weak economic growth.

As a symbol of the fragility of the economy after the start of the war, activity in the eurozone's dominant services sector decreased at its fastest pace since February 2021, PMI surveys showed in May. Gross domestic product in the eurozone expanded just 0.1% in the first quarter, and growth is set to remain subdued in the second.

"With still high uncertainty and a lack of strong evidence of second-round effects, the ECB rate hike we expect in June stands firmly in the camp of pre-emptive hikes," Morgan Stanley economists said in a note ahead of the inflation print.

While inflation in France, Italy and Spain picked up in May, it declined in the eurozone's largest economy, Germany, mainly on the back of a fuel-tax cut introduced at the start of the month.

Oil prices have cooled a little in recent weeks, though remain around 30% higher than in February. However, with eurozone inflation expected to remain above target into next year, eyes now turn to how forceful the ECB's communication next week will be over its concerns of runaway price growth.


Write to Ed Frankl at edward.frankl@wsj.com


(END) Dow Jones Newswires

06-02-26 0814ET