By Balazs Koranyi and Francesco Canepa
FRANKFURT, March 25 (Reuters) – European Central Bank President Christine Lagarde opened the door on Wednesday to raising interest rates in the euro zone if war in the Middle East pushes up euro zone inflation for some time.
The ECB left rates unchanged last week but warned about a looming surge in prices, and policymakers are now debating the conditions that could force them to raise borrowing costs to stop rapid price growth from getting entrenched.
Lagarde said the ECB would have to respond in a forceful or persistent way if inflation looked set to sit well above its 2% target for an extended period, but said even a more modest overshoot could call for a “measured” rate move.
“If the shock gives rise to a large though not-too-persistent overshoot of our target, some measured adjustment of policy could be warranted,” Lagarde said in Frankfurt.
“To leave such an overshoot entirely unaddressed could pose a communication risk: the public may find it difficult to understand a reaction function that does not react,” she argued.
Her warning came as the impact of a widening war in Iran made itself felt in the euro zone economy, sapping German business morale and leading economists around the euro zone, most recently in Portugal and Italy, to warn of slower growth or even recession.
Bank of Finland governor Olli Rehn said at the same event that the ECB should look beyond swings in oil prices and focus on the overall state of the economy.
“Monetary policy must respond, from the standpoint of medium-term price stability, to the overall macroeconomic environment, not to oil prices alone,” the Finnish member of the ECB’s Governing Council said.
ECB TO REASSESS SCENARIOS AT EVERY MEETING
Lagarde did not explicitly equate her criteria with any of the economic scenarios outlined by the ECB last week. However, they are not too different from the inflation trajectory in the bank’s “adverse” scenario.
In the ECB’s most benign “baseline” case, inflation will average 2.6% this year, rising from around 2% in the past year.
In the adverse scenario, inflation will peak above 4% in the second half of this year but return to target by mid-2027, while in the severe option, inflation peaks above 6% early next year and does not return to target for years to come.
“If we expect inflation to deviate significantly and persistently from target, the response must be appropriately forceful or persistent,” Lagarde said. “Otherwise, self-reinforcing mechanisms would kick in and the risk of de-anchoring would become acute.”
Speaking after Lagarde, ECB chief economist Philip Lane said policymakers would judge which scenario best fits “at every meeting,” effectively keeping April or June in play for a first move.
Lagarde said the bank stood ready to act “at any meeting” and, while it would wait for “sufficient information” before shifting policy, it would not allow itself to be “paralysed by hesitation.”
SEARCHING FOR EARLY WARNING SIGNS
The ECB must now be on the lookout for early warning signs that the shock is embedding in broader inflation dynamics and it needs to identify such spillovers, including through wages or inflation expectations.
“As expected deviations from our inflation target grow larger and more persistent, the case for action becomes stronger,” she argued.
Lane flagged companies’ price-hike expectations and wages for new hires as some of the key indicators that the ECB would monitor.
Financial investors now expect two to three rate hikes from the ECB this year as they see inflation above the ECB’s 2% target for several years.
Lane also noted, however, that financial markets had priced in a “price-level jump” in the euro zone as a result of higher energy prices, rather than a persistent rise above target.
SMALL, EARLY HIKES?
Part of investors’ argument for early but smaller action is that the ECB came under fire for acting too late during the 2021-2022 inflation surge.
The bank believed the spike to be transitory and did not raise interest rates until inflation was around 8%, four times its target.
But Lagarde argued that the current situation was different.
The energy shock is so far smaller, especially in the case of natural gas, the labour market is not as tight, there is no post-pandemic pent-up demand, fiscal policies are tighter and the central bank rate is higher, she said.
She argued that historical evidence suggests that the risk of broad pass-through from energy prices is the exception rather than the rule — a point echoed by Bank of Finland’s Rehn.
“An energy price spike is always a drag, but its effect on overall inflation depends on the state of the economy which it hits,” Rehn said.
Nearly two-thirds of economists polled by Reuters expect the ECB to hold interest rates steady this year.
(Additional Reporting by Reinhard BeckerEditing by Tomasz Janowski, Keith Weir and Bernadette Baum)
