ECB’s Lagarde: ‘Withdrawing Accommodation May Not Be Enough’

4 November 2022

By David Barwick – FRANKFURT (Econostream) – European Central Bank President Christine Lagarde on Friday said that the ECB’s job was far from done and that the withdrawal of accommodation might not be sufficient.

At a lecture organised by Eesti Pank in the Estonian capital, Lagarde said that euro area inflation was ‘far too high’ and, given the shocks behind it, ‘likely to stay above our target for some time.’ It is up to monetary policy whether high inflation is lasting, she said. ‘And we will not allow that to happen.’

‘We will therefore have to raise rates to levels that will deliver our 2% medium-term inflation target’, she said. ‘The ultimate goal of our interest rate path is clear, and we are not there yet.’

‘Our job is far from being completed’, she said. ‘And withdrawing accommodation may not be enough to bring inflation back to our target.’

Inflation prospects were the ‘first and most important’ factor in the determination of the terminal rate and the speed of policy adjustment, and would reflect economic prospects, wage developments, expectations and the persistence of shocks, she said. ‘Current inflation numbers are relevant insofar as they provide additional insights about the persistence of inflation’, she added.

Second to inflation prospects was ‘the corresponding policy stance and its transmission lags into demand and inflation’, which, in conjunction with high uncertainty, implied a state-contingent rate path, she said. More persistent inflation would thus oblige monetary authorities to tighten policy further without waiting for the effect of previous measures to come on line, she said.

The ECB’s reaction function also hinged on the ramifications of other policies for inflation, she said.

‘With the economy slowing and real incomes falling, fiscal policy could shift towards a more expansionary stance over and above the contribution from the automatic stabilisers’, she elaborated. ‘But in a supply constrained environment, that can exacerbate inflationary pressures and force the central bank to tighten policy by more than would otherwise be necessary.’

According to Lagarde, a looming decline of demand due to pressure on real incomes and the petering out of pent-up pandemic demand, as risks of recession were rising, would limit the risk of second-round effects. Simultaneous monetary tightening in multiple jurisdictions could aggravate the economic slowdown, she said, though this should not be expected to ‘make a significant dent in inflation, at least not in the near term.’

Nor would weaker external demand necessarily dampen euro area short-term inflation, she said, citing ECB research showing that the impact of tighter US policy on inflation here was in the medium term, whilst euro depreciation in the short run stoked euro area inflation.

‘In this context, we are likely to see wages “catching up” to some extent with higher inflation, since the conditions are in place for workers to try to recoup losses in their real income’, she said, observing ‘forward-looking indicators showing little sign of weakening.’

‘Inflation expectations have been creeping up’, she continued, as governments are being increasingly urged to institute wage indexation.

‘These developments do not constitute excessive second-round effects so far, and at longer horizons inflation expectations remain anchored’, she said. ‘But with inflation likely to remain high for an extended period, we need to monitor inflation expectations and wage negotiations very carefully to ensure that wage growth does not settle persistently at levels that are incompatible with our target.’

According to Lagarde, high inflation was in approximately equal measures demand- and supply-side in nature, and, compared to past experience, the pass-through of shocks to inflation has been both ‘much faster, lasting only around half a year’ and ‘more intense … with firms maintaining and, in some sectors, even increasing their profit margins.’

‘Even if some of the drivers can be expected to soften as bottlenecks ease, reopening effects fade out and energy prices stabilise, standard measures of underlying inflation in the euro area now range from around 4% to 8%’, confirming the deep impact of external shocks, she said.

In addition, the lasting rupture in the supply of Russian gas and the need to speed up the green transition implied structural changes that would prolong the impact of the shocks, whilst a re-evaluation of global value chains based on geopolitical considerations and shifting attitudes towards and in China would also foster price pressures, she said.