Euro Zone Inflation Hits 3-Year Low, Paving the Way for September Rate Cut

Inflation Cooling and Core Rate Stability

The inflation decline from 2.6% in July was anticipated by economists polled by Reuters. Meanwhile, the core inflation rate — which excludes volatile components such as energy, food, alcohol, and tobacco — edged down slightly to 2.8% from 2.9% in July. This was also in line with market expectations.

The euro weakened slightly against the British pound, trading 0.1% lower at 0.8408 pounds, but it gained 0.04% against the U.S. dollar, trading at $1.1083. Investors are looking ahead to a potential rate cut from the ECB in September, following the bank’s first reduction in June, with another 25-basis-point cut expected before the end of the year.

German Inflation Cools

Germany, the euro zone’s largest economy, saw inflation fall to 2% on a harmonized basis, contributing to the overall decline in eurozone inflation. ING economists, however, caution that core inflation in the euro area is expected to stay above 2.5% for the rest of the year, especially due to persistent inflation in goods and services.

Kyle Chapman, a foreign exchange markets analyst at Ballinger Group, noted that the fall in inflation was driven by lower energy prices but warned that underlying inflation pressures remain. "The positive headline is purely down to energy price effects, and it masks the fact that little real progress in underlying pressures has been made here," Chapman said in a note.

He pointed out that services inflation, which rose to 4.2%, remains a concern for ECB policymakers. "Now at the highest level since last October, services inflation has been glued to the 4% area for almost a year now and has headed in the wrong direction since the spring," Chapman added.

ECB's Focus on Wage Inflation

Ed Smith, co-chief investment officer at Rathbones Asset Management, said in an interview with CNBC’s Squawk Box Europe that the ECB remains cautious, particularly regarding wage inflation. ECB President Christine Lagarde has been focused on wage growth as a key indicator, especially given that 80% of the eurozone workforce has their wages negotiated.

Smith noted that negotiated wages in the eurozone saw a significant drop in the second quarter, along with declines in other wage indicators, such as job listings on Indeed.com and business surveys conducted by the ECB. However, he cautioned that some inflation stickiness remains, particularly in services.

"But there is some stickiness, the latest [purchasing managers’ index] numbers, service sector surveys showed some stickiness in the price components of that," Smith said, indicating that this may keep some ECB members wary of aggressive rate cuts.

Market Expectations for Further Cuts

Markets have fully priced in a 25-basis-point rate cut in September, but concerns about services inflation may temper further cuts. The ECB’s cautious approach is balanced between reducing inflation and addressing persistent wage pressures that could reignite price growth in the future.