By Francesco Canepa
FRANKFURT (Reuters) -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 reach its goal of fully reining 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.
"These numbers strengthen the hands of those who say we need to be cautious," Dirk Schumacher, an economist at Natixis, said.
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% target after increases of 2.4% in the previous two months, according to Eurostat's flash estimate.
Economists polled by Reuters had anticipated inflation would rise to 2.5%, fuelled in part by an unfavourable comparison to last year when Germany had subsidised rail travel, among other one-off factors.
ECB policymaker Fabio Panetta, the governor of the Bank of Italy, said the latest reading was neither good nor bad as he reaffirmed his view that the central bank could cut rates several times and still keep the brakes on the economy.
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, which reached from 10% in late 2022 due to the surge in energy prices in the wake of Russia's invasion of Ukraine. The hikes have stabilised consumer inflation expectations but 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.
"We think that the latest inflation and wage figures decrease the likelihood of back-to-back interest rate cuts in July, but we see the ECB cutting rates twice more before the end of the year if the downward trend in inflation resumes during the third quarter as expected," said Diego Iscaro, head of European economics at S&P Global Market Intelligence.
German government bond yields - the benchmark for euro zone borrowing costs - reached their highest in over six months after inflation data was released.
Markets are currently pricing around 57 basis points of ECB rate cuts in 2024, and are indicating a 25 basis point cut in June, and one more by year end. In recent weeks, however, they have been gradually paring back expectations of a third cut this year.