The nature of the euro zone’s inflation problem is changing and interest rates will have to stay higher for longer than policymakers and investors believe, Christine Lagarde, European Central Bank President, said on Tuesday.
While the shocks that pushed the region’s inflation rate above 10 percent late last year, such as supply chain shortages during the pandemic and the rise in energy prices following the Russian invasion of Ukraine, are beginning to recede, their impact is still being felt the economy off. This will make inflation more persistent, Ms Lagarde said at the central bank’s 10th annual conference in Sintra, Portugal.
The slower decline in inflation “is caused by inflation working in stages through the economy as different economic agents try to pass the cost on to each other,” Ms Lagarde said. Businesses have passed on the costs to customers and now workers are trying to make up for the lost wages caused by high prices.
Central bankers from across Europe and beyond, from Canada to South Africa – including Federal Reserve Chairman Jerome H Powell and Bank of England Governor Andrew Bailey – have gathered in Sintra at a difficult time for policymakers to fight for it to bring down inflation without causing unnecessary economic damage.
Central banks around the world have been aggressively raising interest rates, and while the full impact of these moves is yet to be felt in various economies, policymakers are trying to figure out if they have the inflation problem under control.
The European Central Bank, which sets policy for the 20 countries that use the euro, this month raised interest rates to their highest levels since 2001 and said more hikes were likely to follow. Eurozone consumer prices rose 6.1 percent year-on-year in May, the slowest rise in more than a year.
But policymakers are still concerned about core inflation, which ignores food and energy prices and is a way of measuring how deeply embedded price pressures are in the economy. That figure fell to 5.3 percent in May from 5.6 percent in the previous month.
The central bank “must bring interest rates to sufficiently restrictive levels and keep them there for as long as necessary,” Ms Lagarde said on Tuesday.
For euro-zone inflation to return to the central bank’s target of 2 percent, companies will have to face higher labor costs and lower profit margins, she added.
Last year, companies were able to pass on higher costs quickly, in part because customers couldn’t tell whether the higher prices were caused by high corporate costs or the pursuit of higher profits, she said. So earnings contributed about two-thirds to domestic inflation, compared to the one-third average over the past two decades.
Workers are now demanding higher wages to compensate for their lost purchasing power. The central bank projects wages will rise 14 percent by the end of 2025 when they return to pre-pandemic levels, adjusted for inflation.
If monetary policy is tight enough, inflation could be brought down and workers could make up some of the lost wages, Ms Lagarde said. For this to work, policymakers must slow down the economy by dampening demand so companies cannot fully pass on the cost of higher wages to their customers. If not, inflation will remain stubbornly high.
The central bank must adopt “more insistent policies” to counter signs of prolonged inflation, Ms Lagarde said. That means keeping interest rates at restrictive levels until policymakers are confident that the wage catch-up process is resolved.
“We’ve made significant progress,” Ms. Lagarde said. “But in the face of a more sustained inflationary process, we cannot waver and cannot yet declare victory.”
The central bank will not be able to say with certainty in the short term whether interest rates have peaked, she added.
The day before, the central bankers received an urgent warning from the International Monetary Fund. “It’s taking too long for inflation to get back on target,” said Gita Gopinath, the organization’s first deputy executive director, in a speech.
Ms Gopinath set the tone for the conference, which runs through Wednesday, arguing that despite the economic cost, central banks still need to go further to bring down inflation.
Despite the actions taken by global central banks, “the fight will not be easy,” Ms. Gopinath said. “Financial stresses could intensify and growth may need to slow more.”
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