Lagarde gives the anatomy of “her” strategy to combat inflation and warns: “’Soft landing’ is not yet guaranteed”.
With May data from Eurostat confirming a rise in the inflation rate to 2.6%, the European Central Bank remains cautious in relation to the interest rate relief cycle, which will not be as fast as the uphill cycle. In the speech that opened the ECB Monetary Policy Forum this Monday, July 1, the president of the euro central bank, Christine Lagarde, justified the strategy followed by the ECB in recent years to limit the rise in prices you.
He also warned that “given the magnitude of the inflation shock, a “soft landing†is not yet guaranteed,†and said that the central bank will not hesitate to take further action to bring the inflation rate closer to the defined target, if necessary.
And he resorted to a football image, appropriate to having started his intervention simultaneously with the start of Portugal – Slovenia: “We will not waver in our commitment to bring inflation back to our objective, for the benefit of all Europeans. As the late football player and coach Sir Bobby Robson said, “the first 90 minutes are the most important†. In the same way, we will not rest until the game is won and inflation is back to 2%,” he concluded.
“Our work is not finished and we must remain vigilant,†reiterated Lagarde, who recognized this uncertainty as “a profound challenge for political decision-makers.†She added that the extraordinary nature of the inflationary outbreak, caused due to unique and profound shocks, the ECB still has to be very prudent in its vigilance. In short, the status quo of recent years remains: “All this reinforces our determination. in being dependent on data and making our political decisions meeting by meeting.â€
This is because, according to the president, doubts remain regarding the behavior of indicators under particular scrutiny in recent years: “We are still facing several uncertainties in relation to inflation. future, especially in terms of how the link between profits, wages and productivity will evolve and whether the economy will be hit by further supply-side shocks. And it will take time to gather enough data to be sure that the risks of above-target inflation have been overcome,’ she said.
“Sense of urgency” in 2022
Lagarde took the opportunity to make a long justification for the central bank’s actions in recent years, which were heavily criticized on both sides of economic science. During the contraction cycle, a front of critics considered the sudden and strong growth in rates as unnecessarily punitive for economies emerging from a pandemic recession. On the other side, the “falcons†called for a much more aggressive strategy, fearing that the population would begin to disbelieve in the ability of the rate of price rise to be effectively controlled by the bank.
It was this last concern that the ECB focused on. It was important that people did not lose confidence in the central bank’s ability to control inflation, given the return of the issue to the population’s imagination. “The shocks were big enough that many families started paying more attention to inflation. In early 2023, more than 60% of responses to our consumer expectations survey reported that they were paying more attention to inflation than in the past,” said Lagarde.
Furthermore, another risk could come from a price-wage spiral, in which the two feed each other, with workers compensating for the loss of purchasing power through wage increases, and companies balance this extra cost with price increases: “The inflationary impact of the shocks ran the risk of becoming persistently endogenous, mainly due to the progressive wage negotiation process in the eurozone†.
“We saw some signs that the anchoring of inflation expectations was becoming more vulnerable” when, “in October 2022, about four in ten consumers expected inflation medium-term inflation was equal to or greater than 5% and professional forecasters assigned a 30% probability of inflation being equal to or greater than 3% two years later. Therefore, monetary policy had to send a strong signal that permanent excesses of the inflation target would not be tolerated,” he stressed.
“Thus, we strongly emphasize our determination to ensure a “timely†return to the objective. Our goal was to convey our commitment to ensuring that the period of high inflation would be limited and to signal a sense of urgency,” Lagarde added.
Pay attention to data in 2023
At first, it was not known exactly which component was most important in causing the inflationary outbreak: supply or demand. Studies available in 2022 suggested different conclusions. One of them indicated “that, at their peak, supply shocks were three times more important than demand shocks in explaining the deviation of inflation from its average†, while other studies – œgave more emphasis to demand shocks.†This meant that the ECB, in its decisions, gave more importance to the “size and persistence†of the shocks, and not to the specific behaviors of supply and search.
Hence the need to communicate this “sense of urgency†, recognized Lagarde. However, “it was clear from the beginning that simply communicating our commitment to achieving the objective would not have been enough. The ECB’s analysis shows that if we had not reacted, the risk of de-anchoring would have been more than 30% in 2023 and 2024. Even moderate policy action is likely was insufficient. For example, if rates had stopped at 2%, the risk of unanchoring would still have been around 24%.â€
Hence the rapid interest rate rise curve: “So when we started raising rates, we knew we were far from where we needed to be. The most important factor was therefore to close the gap as quickly as possible. That’s why we had a historically steep rise at the beginning of our rate path, using 75 and 50 basis point increments for our first six increases.
As the “peak” approached, “the challenge shifted from acting quickly to accurately calibrating the trajectory. In particular, we needed to define a rate trajectory that provided both a ‘timely’ return to the 2% and did with a high degree of confidence.” From here on, any decision would have to be “data-dependent†, or dependent on data analysis, the mantra adopted by the ECB to justify its strategy.
The costs of contraction
But – and especially after historic recessions caused by the covid-19 pandemic – this strategy also had its costs; considered inevitable but, even so, and according to the ECB’s own assessment, smaller, so far, compared to previous contraction cycles. For now.
This “dampening of economic growth†, worsened by rising interest rates “while the economy stagnated for five consecutive quarters†, is considered “inevitable when central banks face shocks that push up inflation. ion and the product in opposite directions.â€
But in this case, “inflation peaked much higher than during previous soft landings, but also slowed more quickly. Growth remained within the range of previous soft landing episodes, although near the bottom of that range. And the performance of the job market has been exceptionally benign,” he acknowledged.
“This time, the costs of disinflation were contained compared to similar episodes in the past,†said Lagarde. Which led her to conclude that “given the magnitude of the inflation shock, a “soft landing†is still not guaranteed†.
