Euro zone inflation surges, keeping pressure on ECB to hike

FRANKFURT, Oct 2 (Reuters) - Euro zone inflation surged more than expected in September and is likely to increase further in the coming months on soaring energy costs, keeping pressure on the European Central Bank to raise interest rates even higher.

Inflation in the 21 nations sharing the euro currency jumped to 3.8% in September from 3.2% a month earlier, in exceeding expectations for 3.6% in a Reuters poll, driven primarily by fuel, natural gas, and to a lesser extent, by food costs.

A closely watched 'core' figure, which excludes volatile food and fuel prices and signals underlying trends, meanwhile picked up to 2.5% from 2.4%, on a pick up in services prices, data from Eurostat, the EU's statistics agency, showed on Friday.

The figures are likely to be seen as a mixed bag for the ECB.

The rise in headline inflation further above its 2% target is worrisome and will bolster calls for rate hikes on top of the two moves this summer. 

WILL ECB MAINTAIN ITS 'MEASURED' POLICY RESPONSE?

But the muted increase in core figures indicates that high energy costs have yet to generate the sort of second-round impacts that could set off a hard-to-break inflation spiral. 

These would suggest the ECB can stick to its 'measured' policy response, an undefined concept taken by markets to mean spaced-out rate hikes, perhaps to coincide with quarterly economic projections.

Indeed, investors see up to three more hikes in the ECB's 2.5% deposit rate in the coming year but the odds of a move this month are seen as negligible and the next increase is not fully priced in until January.

These expectations change rapidly, however, and even policymakers acknowledge that their own projections are far too uncertain.

Policy hawks argue that energy costs have been too high for too long, so they are bound to start setting off second-round effects, and the recent surge in natural gas costs will feed into core prices more quickly than in the past, lifting everything from electricity and heating costs to business expenses.

But others say the labour market is relatively soft, so workers can hardly demand big pay increases, and the recent sharp increase in longer-term borrowing costs is also bound to curtail price growth.

Ultimately, the clincher for the next rate decision may be considerations for financial stability rather than inflation. 

Borrowing costs have soared, mostly as the blowout in US yields to a 24-year high affects every borrower. But investors are also demanding a greater premium to hold riskier assets and the spread on French debt over similar German bonds has risen to multi-decade highs, raising debt sustainability questions. 

Economists say the ECB may be keen to stay on the sidelines for now and not add to the turbulence, especially since inflation trends do not require urgent or forceful action.    

(Reporting by Balazs KoranyiEditing by Gareth Jones)