Eurozone inflation at record high as Omicron dents economic rebound

Eurozone’s inflation rate hit a record high in December as the economy came under renewed stress amid surging Omicron infections and tighter restrictions.

Annual inflation in the 19 countries sharing the euro rose to 5 per cent, from 4.9 per cent the previous month, according to the European Union’s statistics agency Eurostat, with energy prices the main driver with an uplift of 26 per cent.

"European inflation hit a new high 5 per cent, above expectations and accelerating for a sixth month. This is the highest rate since 1985, but likely near peak levels and lower than the US,” said Ben Laidler, global markets strategist at multi-asset investment platform eToro.

"Prices are being driven by supply chain disruptions and higher energy prices. For example, European natural gas prices have risen fivefold in the last year. The European Union is seeing widely different price rises, with inflation in France and Italy only 2.8 per cent and 3.9 per cent respectively, versus Germany’s 5.3 per cent and Spain’s 6.7 per cent price surge.”

With infections breaking records almost daily as the Omicron variant sweeps across Europe, eurozone growth is expected to take a hit at the start of this year even though governments have largely avoided the restrictive measures that brought their economies to a standstill a year ago.

“The latest surge in Covid infections makes us expect first-quarter growth to be slower than previously anticipated,” said Nicola Nobile at Oxford Economics.

“However, assuming that the health situation does not lead to hard lockdowns, we expect the economy to recover the lost ground by mid-year, with the impact over this year as a whole being very mild."

Meanwhile, the European Commission's Economic Sentiment Indicator, a key gauge of the bloc's economic health, fell more sharply than forecast in December to a level last seen in May, with the outlook for services significantly worse and employment expectations also down.

The slowdown is already evident in the bloc’s biggest economy, Germany, where supply chain bottlenecks have held back the country’s vast factory sector for most of the last quarter, with industry unexpectedly stumbling in November.

Output fell 0.2 per cent on the month, reinforcing views that the German economy stalled in the fourth quarter of last year, with no relief in sight for months.

"Unfortunately, this is where the rebound of German industry stops for the time being. The fourth wave of the pandemic and Omicron should send industrial activity back into hibernation," ING economist Carsten Brzeski said.

The only bright spot for the eurozone economy was its retail sales, which rose 7.8 per cent compared with a year earlier and 1 per cent on the month, driven by in-store non-food purchases, indicating that consumer demand was healthy even as new pandemic-related restrictions were implemented.

But heavy spending by households, who had little choice but to stash their cash over the past year during restrictions, is pushing consumer prices to new records.

Higher inflation should be short-lived, according to economists, once high energy prices drop off.

“We suspect that December was the peak in eurozone inflation. Base effects related to Germany’s VAT cut in the second half of 2020, together with the re-weighting of items in the HICP basket, are likely to knock about 0.5 per cent off headline inflation in January this year,” said Jack Allen-Reynolds, senior Europe economist at Capital Economics.

“Meanwhile, energy inflation is almost certain to drop sharply. We forecast that the contribution of energy to headline inflation will fall from 2.5 per cent in December 2021 to around zero in December this year.”

While most of the inflation drivers are temporary, many analysts, including some influential policymakers, doubt the European Central Bank’s benign narrative that price growth will be back below its 2 per cent target by the end of the year.

Part of their concern is that increases in underlying prices – or inflation excluding volatile food and fuel prices – are also above target, suggesting that sectors prone to weak inflation over the past decade are now adjusting.

"We believe we are near peak inflation, as supply chains loosen, and well below US levels of 6.8 per cent,” Mr Laidler said.

“This is keeping the ECB dovish, with no interest-rate increase expected this year. It is also keeping the euro weak, a key support for European company profits and exports."