The nature of the inflation problem in the eurozone is changing and interest rates will have to be higher for longer than policymakers and investors once estimated, Christine Lagarde, the president of the European Central Bank, said on Tuesday.
While the shocks that pushed the region’s inflation rate above 10 percent late last year, such as supply chain bottlenecks during the pandemic and the spike in energy prices following Russia’s invasion of Ukraine, have begun to subside, their impact is still rippling through the economy. That makes inflation more persistent, Lagarde said at the central bank̵[ads1]7;s 10th annual conference in Sintra, Portugal.
The slower decline in inflation “is caused by the fact that inflation works its way through the economy in phases, as different economic actors try to pass the costs on to each other,” Lagarde said. Businesses have passed costs on to customers, and now workers are trying to make up for lost wages caused by high prices.
Central bankers from across Europe and further afield, from Canada to South Africa – including Jerome H. Powell, chairman of the Federal Reserve, and Andrew Bailey, governor of the Bank of England – have gathered in Sintra at a challenging time for policymakers as they battle to bring down inflation without causing unnecessary economic pain.
Central banks around the world have aggressively raised interest rates, and while the full impact of these moves has not yet been felt in various economies, policymakers are trying to determine whether they have control over the inflation problem.
The European Central Bank, which sets guidelines for the 20 countries that use the euro currency, raised interest rates this month to the highest level since 2001 and said more increases were likely to follow. Consumer prices in the eurozone rose 6.1 percent in May from the previous year, the slowest pace in more than a year.
But policymakers remain concerned about core inflation, which strips out food and energy prices and is a way of measuring how deeply price pressures are embedded in the economy. This target fell to 5.3 per cent in May, from 5.6 per cent the previous month.
The central bank “must bring interest rates to sufficiently restrictive levels and keep them there for as long as necessary,” Lagarde said on Tuesday.
For inflation in the eurozone to return to the central bank’s target of 2 percent, companies must absorb higher labor costs and accept lower profit margins, she added.
Last year, businesses were able to pass on higher costs quickly, in part because customers were unable to discern whether higher prices were caused by high business costs or the pursuit of greater profits, she said. So profits contributed about two-thirds to domestic inflation, compared with an average of one-third over the previous two decades.
Workers are now seeking higher wages to make up for lost purchasing power. The central bank expects wages to rise by 14 percent by the end of 2025 as they return to pre-pandemic levels, when adjusted for inflation.
Inflation can be pushed down, and workers can make up for some lost wages, if monetary policy is restrictive enough, Lagarde said. For this to work, the policy must constrain the economy by dampening demand so that businesses cannot fully pass on the costs of higher wages to their customers. If that doesn’t happen, inflation will remain stubbornly high.
The central bank needs to have “more sustained policy” to tackle signs of prolonged inflation, Lagarde said. That means keeping interest rates at restrictive levels until decision-makers are sure that the wage recovery has been resolved.
“We have made significant progress,” Lagarde said. “But in the face of a more persistent inflationary process, we cannot waver, and we cannot declare victory yet.”
The central bank will not be able to say with certainty in the short term whether interest rates have peaked, she added.
The night before, central bankers received a stern warning from the International Monetary Fund. “Inflation is taking too long to return to target,” Gita Gopinath, the organization’s first deputy managing director, said in a speech.
Gopinath set the tone for the conference, which runs until Wednesday, arguing that central banks needed to go further to bring down inflation, despite the economic costs.
Even with the actions global central banks have taken, “the fight is not going to be easy,” Gopinath said. “Financial strains may intensify, and growth may have to slow down more.”