Central banks expect that labor costs will have the majority impact on inflation, expected deposit interest rate in June 3.50 percent

This year, a positive effect of the normalization of supply chains, significantly more favorable expectations regarding energy prices in the second half of the year, and generally strong slowing of aggregate demand on the prices of goods and services is expected, as stated by HUP in the Focus of the week.

A strong decline in six-month expectations of selling prices in the euro area has been suggesting significantly lower import inflation for some time. However, all of this still does not mean that high inflation is completely under control, given the warnings from central banks about the rapid recovery of real incomes.

Earlier but expected real improvements in wages in Croatia are a reflection of slowing inflation, strong growth in the minimum wage (+12.2 percent), a series of indexations at the beginning of the year, along with continuous labor market tension that puts pressure on wage growth in the real sector and raises wage demands in the public sector.

The strong dynamics of wage growth now strengthen the expectations of central banks that this year the majority impact on inflation will come from unit labor costs and that core inflation remains elevated.

Despite the strong decline in market spot prices of energy (crude oil, gas, electricity), wholesale European gas prices for summer 2025 (as a proxy for companies considering a two-year contract) are still nearly four times higher compared to the pre-pandemic period.

Some actors also do not rule out disruptions in the energy market before autumn or winter.

Reduction of the bond portfolio

– At the next ECB meeting on June 7, we expect a further increase in the deposit rate by 25 basis points to 3.50 percent in line with the high level of core inflation. This could easily be the last rate hike given the decline in producer prices, the expected easing of core inflation, and the growing probability of a (technical) recession in the euro area, when a peak in core inflation is also expected, states the chief economist of HUP, Hrvoje Stojić, in the Focus of the week.

In the absence of excessive volatility in global financial markets, the ECB could maintain the deposit rate at 3.50 percent as long as core inflation remains significantly above the target level of 2 percent due to relatively strong growth in employee incomes.

Additionally, starting in June, the ECB is accelerating the reduction of the bond portfolio purchased through the conventional (QE) quantitative easing program since 2015. By an additional 15 billion euros per month, and already in July, the ECB will completely stop reinvesting maturing bonds.

This corresponds to an average reduction of the ECB’s balance sheet of 25 billion euros per month, with the monthly volume of maturities varying significantly from month to month. At the same time, the ECB will fully reinvest maturing bonds from the Pandemic Emergency Purchase Program (PEPP) until the end of 2024.

Although these moves free up space for the growth of long-term interest rates, there are still downward risks regarding their movement. The latter include the renewal of stress in American banks, stronger tightening of public finances, and a (technical) recession in the euro area.