Euro Zone Inflation Surprises in May: ECB Faces Tough Decisions

Euro zone inflation rose to 2.6% in May, surpassing expectations and complicating the European Central Bank's efforts to lower borrowing costs. Despite the increase, which was influenced by higher wages and strong domestic demand, the ECB may still cut rates next week but could opt for a slower pace in the months ahead.

Euro zone inflation rose in May, data showed on Friday, in a sign the European Central Bank still faces a slow and uncertain journey to rein in prices. The bigger-than-expected increase in inflation was unlikely to stop the ECB from lowering borrowing costs from a record high next week, but may cement the case for a pause in July and a slower pace of interest rate reductions in the coming months.

Consumer prices in the 20 countries that share the euro rose by 2.6% year on year in May, inching away from the ECB's 2% goal after increases of 2.4% in the previous two months, according to Eurostat's flash estimate. Economists polled by Reuters had anticipated a 2.5% increase although an upside surprise was likely after German, French and Spanish readings earlier.

More significantly, a closely watched measure of underlying inflation that excludes food, energy, alcohol and tobacco came in at 2.9% from 2.7% in April. Prices in the services sector, which some policymakers have singled out as especially relevant because they reflect domestic demand, rebounded to 4.1% from 3.7%.

This was likely to mirror larger-than-expected increases in wages in the first quarter of the year, which have boosted consumers' battered disposable income after years of below-inflation pay hikes. The ECB's biggest ever streak of rate hikes has helped bring down inflation from a whopping 10% in late 2022 and stabilised consumer expectations but it has also choked off credit.

This meant that policymakers meeting next week were likely to stick to well-telegraphed plans to cut rates despite growing market doubts about a global narrative of falling inflation. (Reporting By Francesco Canepa; Editing by Toby Chopra)