Lagarde’s hawkishness reflects Europe’s stickier inflation problem

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Christine Lagarde used to claim that the Federal Reserve had a bigger inflation problem than the European Central Bank. Now the ECB chief admits the eurozone may be in a bigger mess.

The risk of inflation staying uncomfortably far above the 2 per cent level targeted by both central banks was now greater here than on the other side of the Atlantic, Lagarde acknowledged after the ECB’s decision to raise interest rates by half a percentage point to 2 per cent on Thursday.

US inflation is now falling following a series of aggressive rate rises by the Fed which have put borrowing costs within a range of 4.25 per cent to 4.5 per cent. However the ECB, which began raising rates later than its US counterpart, could be faced with a further bout of inflation. Lagarde said there were “reasons to believe” price pressures in Europe would surge in early 2023.

The implication for monetary policy is that interest rates here have much further to climb than in the US.

While the ECB slowed the pace of rate rises from a three-quarter point increase at its last meeting, in line with the Fed and Bank of England this week, Lagarde stressed that investors should not see this as a sign it was about to stop.

The ECB president said it was “tempting to assume that all central banks are doing the same thing all the time”. But Lagarde added: “If you compare us to the Fed, we have more ground to cover, we have longer to go”. She warned of a further half-point rate rise at the ECB’s next meeting in February and “possibly the one after that and possibly thereafter.”

Dashing hopes that the ECB could stop its rate rises soon, she said: “We are not slowing down. We are in for the long game.” 

US consumer price inflation fell back to 7.1 per cent in November, but in the eurozone the equivalent figure remains in double digits at 10 per cent — albeit slightly lower than the 10.6 per cent reading for October.

But Lagarde’s hawkishness is less about the headline number and more about the different nature of inflation in two of the world’s most powerful economies.

US inflation has been driven more by an overheating economy, tight labour market and sharply rising wages. In contrast, inflation in the single currency bloc has been mainly driven by soaring energy and food costs, stemming from the fallout of Russia’s invasion of Ukraine.

Early this year, several ECB officials including Lagarde said this meant the Fed had to act more aggressively to restrict domestic demand than they did because rate rises would do little to increase the supply of energy or food.

But the ECB president seems to now fear that, as high energy prices feed through to people’s utility bills and push up prices of other goods and services, inflation could prove stickier in Europe than the US.

Core inflation — which excludes changes in the cost of energy and food, and seen as a better measure of underlying price pressures — is also falling in the US, unlike in the eurozone where it stayed flat at 5 per cent in November.

“The ECB is clearly concerned about elevated inflation getting entrenched via second-round effects, with recent wage developments probably flashing red,” said Silvia Dall’Angelo, economist at Federated Hermes, an investor. “The ECB feel like their very credibility is on the line and, accordingly, are determined to err on the hawkish side, at the risk of overdoing it.”

Some eurozone policymakers, such as ECB executive board member Isabel Schnabel, have also warned that government policies to cushion households and businesses from soaring energy prices will keep eurozone inflation higher for longer.

The ECB on Thursday underlined its concern over the stickiness of inflation by raising its forecasts for price growth over the next three years and predicting it would still be above its target — at 2.3 per cent — even in 2025.

Although euro area inflation may dip in December, Lagarde warned that “we have reasons to believe that January and February numbers could be a little higher,” as this is when many people’s annual utility contracts are renewed.

“There are countries where the prices have not yet passed through fully to the retail level and people have not seen the full impact yet and particularly in energy,” she said, adding that further increases in food prices had also been a key factor behind the higher forecasts.

Several economists said the ECB was too pessimistic on inflation, and over-optimistic on growth. The bank expects eurozone growth to slow from 3.4 per cent this year to 0.5 per cent next year before rebounding to 1.9 per cent in 2024. Any recession would be shallow and shortlived, the ECB thinks, giving rate-setters the space to raise borrowing costs again.

“This is the most hawkish ECB press conference we’ve ever covered,” said Claus Vistesen, an economist at Pantheon Macroeconomics. “Lagarde was a woman on a mission today.”

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