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Sticky inflation fuels some of ECB's worst fears

By Balazs Koranyi

FRANKFURT (Reuters) - A surprise surge in underlying inflation across the 20-nation euro zone bolstered bets for more oversized European Central Bank rate hikes this spring, with policymakers fretting that price growth could be even more sticky than feared.

Overall inflation eased a touch to 8.5% last month from 8.6% in January, data on Thursday showed. But nearly all the drop came from lower energy costs, while prices for most other items - including food, services and durable goods - surged again, confirming the worst fears of some ECB policymakers.

A jump in underlying inflation - to 5.6% from 5.3% - reinforces already copious evidence that past price rises are filtering down into the broader economy, including via wages. That will make inflation harder to defeat and require more determined monetary policy tightening.


The ECB has already flagged a half-percentage-point rate hike on March 16 and ECB President Christine Lagarde confirmed that on Thursday, quashing market chatter about a bigger rise and shifting the focus to the ECB's subsequent meeting in May.

"We have every reason to believe that there will be another 50-basis-point increase at our next meeting in March," Lagarde said. "I don't have any reason to believe that it won't be like that."

Markets are also pricing in another 50 basis point hike on May 4, and the accounts of the ECB's February meeting, published on Thursday, did little to challenge those bets.

"Core inflation and other measures of underlying inflation were likely to be stickier, with only limited evidence of a stabilisation so far," the ECB said in the accounts of the Feb. 1-2 meeting.

"Further increases were required for the Governing Council’s policy rates to enter restrictive territory," it said.

One key worry for policymakers is that labour markets are so tight that wage growth, seen between 5% and 6% this year, will fuel price pressures.


Unemployment held steady at 6.7% in January, just above a record low, while employment is at a record high with many firms, particularly in services, complaining about a shortage of workers.

Labour market worries are likely to be exacerbated by better-than-forecast economic growth, which will also exert upward pressure on wages.

"All of this is prompting us to make a second change to our ECB call in a week," JPMorgan economist Greg Fuzesi said. "In particular, we upgrade (the rate hike view in) May from 25bp to 50bp, which takes our terminal rate forecast to 3.75% in June."

Market pricing for ECB rates have moved up so quick that investors are now pricing an extra 50 basis points of rate hikes than a month ago, seeing the peak of rates at just above 4% at the turn of the year.

Recent inflation outcomes are very much in line with recent warnings from conservative policymakers, who appear to command a clear majority on the 26-member Governing Council.

ECB board member Isabel Schnabel has long said that inflation may be more persistent than estimated while Bundesbank President Joachim Nagel this week argued that the recent fall in energy prices has failed to improve medium-term prospects, so that the ECB may need to opt for another large rate hike in May.

On top of raising rates, the ECB is fighting inflation by mopping up some of the 7-trillion-euros' worth of liquidity it poured into the financial system during nearly a decade of aggressive money-printing.

It has been doing so by not renewing long-term loans to banks and, from this month, by not replacing some of the bonds it has bought when they mature.

Schnabel said on Thursday there was still far too much cash sloshing around the banking system, laying the ground for more quantitative tightening (QT) in the coming months.

"Our current estimates suggest that the amount of central bank reserves currently held by the banking sector exceeds, by a significant margin, the level necessary to steer short-term market rates," she said in a speech.

(Additional reporting by Francesci Canepa; Editing by Hugh Lawson and Catherine Evans)