FRANKFURT, March 25 (Reuters) – Even a “not-too-persistent” overshoot of the European Central Bank’s inflation target from the current energy shock may warrant some moderate policy tightening, ECB President Christine Lagarde said on Wednesday.
The ECB left rates unchanged last week but warned about a coming surge in prices and policymakers are now debating under what scenario they would need to raise interest rates to combat the risk of quick price growth getting entrenched.
“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 a speech 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.
Lagarde did not explicitly equate her criteria with any of the 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.”
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.
Financial investors now expect two to three rate hikes from the ECB this year as they see inflation above target for several years.
Part of their 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 quite different and several factors point to a lesser pass-through.
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 also argued that historical evidence suggests that the risk of broad pass-through from energy prices is the exception rather than the rule.
(Reporting by Balazs KoranyiEditing by Tomasz Janowski)
