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UPDATE 1-Euro zone inflation eases in February but core prices surge

(Adds economist comments on rates, labour market)

FRANKFURT, March 2 (Reuters) - Euro zone inflation fell less than expected last month and underlying price growth surged, reinforcing the case for the European Central Bank to keep raising interest rates at a brisk pace, data from Eurostat showed on Thursday.

Consumer price inflation in the 20 countries sharing the euro currency eased to 8.5% in February from 8.6% a month earlier as a big fall in energy costs offset a price surge in nearly all other areas, but still came in above expectations for 8.2% in a Reuters poll of economists.

Although overall inflation is well below its double-digit highs of October it continues to broaden, fuelling fears the earlier surge has seeped into the economy via so-called second-round effects, making it more difficult to root out.

Indeed, underlying inflation, which filters out volatile food and fuel prices, an indicator closely watched by the ECB, jumped to 5.6% from 5.3%, coming well above expectations for a steady reading.

The ECB has promised another half-percentage-point rate hike for March 16 to fight inflation, but grim data is already shifting the debate to subsequent meetings as markets continue to raise their bets on just how high the ECB will need to go.

"Today's print, with core inflation proving still very sticky, not only seals the deal for a 50 bps rate hike in March, but also paves the way for an analogous monetary policy tightening in Q2," Paolo Grignani at Oxford Economics said.

Investors now see the ECB's 2.5% deposit rate rising by a combined 100 basis points in March and May, then to around 4.1% at the turn of the year, with markets having priced in an extra 50 basis points of hikes in the past month alone.

Market pricing has moved up so much that some even see a risk the ECB will hike by more than 50 basis points this month, despite its explicit guidance, which was confirmed again by ECB chief Christine Lagarde on Thursday.


The problem is that underlying inflation is a leading indicator on the durability of price growth and its stubborn rise suggests that getting the headline rate down to the ECB's 2% target may be protracted.

Price growth in services, the biggest component in core inflation, accelerated to 4.8% from 4.4%, a big worry since the sector is especially sensitive to wage growth and the rise suggests an acceleration in labour costs.

Unemployment meanwhile held at 6.7% last month, just above a record low, and all indicators point to a tight jobs market that could push nominal wage growth to above 5% this year.

"High wage increases could imply that especially service price inflation could remain elevated in 2023-2024," Nordea analysts said in a note. "Given that the weight of services in the headline inflation is 44% and in core inflation 62%, elevated service price inflation will keep also the aggregate level inflation high."

Industrial goods inflation meanwhile picked up to 6.8% from 6.7% while unprocessed food price growth surged to 13.6% from 11.3%.

Bundesbank President Joachim Nagel has already argued that the recent fall in energy prices only lowers short-term inflation and does not improve medium-term prospects, so the ECB may need to opt for another large rate hike in May.

But Lagarde argued that disinflation will pick up speed from next month as surging gas prices at the onset of Russia's war in Ukraine get knocked out of base figures. (Reporting by Balazs Koranyi; Editing by Hugh Lawson and Catherine Evans)