Christine Lagarde declares ECB will continue to raise interest rates in July

The European Central Bank is willing to continue its hawkish quantitative tightening policy of raising interest rates next month, president of the ECB Christine Lagarde has said.

Speaking at the ECB Forum on Central Banking 2023 in Portugal today (27 June), the ECB president said: "Barring a material change to the outlook, we will continue to increase rates in July."

Euro area annual inflation was 6.1% in May 2023, down from 7% in April, with the ECB targeting a 2% level, along with other major central banks. 

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The ECB has increased interest rates by four percentage points since last July in a bid to lower inflation, and the continent has "not yet seen the full impact", Lagarde said in a speech, adding the "job is not done".

Inflation in the eurozone has been sent higher in recent months, in part by firms defending their margins and passing cost increases onto consumers, Lagarde told the summit.

The knock-on effect has been workers demanding higher wages to deal with the increased cost of goods and services, which is now taking over as the leading cause of eurozone inflation.

Lagarde said firms must absorb rising wage bills and take the hit to their profits rather than passing the costs on to consumers, in order to lower inflation.

The ECB expects wages to grow by a further 14% between now and the end of 2025, she said, and to fully recover their pre-pandemic level in real terms.

While this "wage catch-up" was factored into the ECB's initial forecasts, unit labour cost pressures have been exacerbated by subdued productivity growth, forcing inflation projections to be revised upwards, she added.

To bring inflation back to the ECB's 2% medium-term target in a timely manner "we need to ensure that firms absorb rising labour costs in margins", Lagarde said.

"If monetary policy is sufficiently restrictive, the economy can achieve disinflation overall while real wages recover some of their losses," she said. 

"But this hinges on our policy dampening demand for some time so that firms cannot continue to display the pricing behaviour we have recently seen."

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In a nod to what some have labelled "greedflation", Lagarde said unit profits contributed around two-thirds to domestic inflation in 2022, whereas in the previous 20 years, their average contribution had been around one-third.

"This in turn led to the shocks feeding into inflation much more quickly and forcefully than in the past," she said, though she added this was now starting to wane.

Sensitivity analysis by ECB staff underlined the risks the eurozone would face if firms tried to defend their margins instead. For instance, if firms were to regain 25% of the lost profit margin that the ECB's projections foresee, inflation in 2025 would be substantially higher than the baseline, at almost 3%.

It is unlikely, Lagarde said, that in the near future ECB will be able to state "with full confidence" that the peak rates have been reached.

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The central bank is monitoring the "transmission" effect on firms and households of higher interest rates, and using it to inform its rate setting.

ECB analysis found monetary policy shocks are typically transmitted more quickly and forcefully to manufacturing, reflecting the sector's higher interest-rate sensitivity, while there is a more muted and delayed impact on services.

For households, there is evidence it will take longer for policy changes to pass through to interest burdens in this tightening cycle, as a higher share of households have fixed-rate mortgages than in the mid-2000s, when interest rates were last higher.

"Once mortgages have been repriced, the restrictive effect may be greater," Lagarde explained, as gross debt-to-income ratios, which emphasise debt servicing capacity, are higher than in previous tightening cycles, while the share of homeowners with a mortgage has increased.

Future ECB policy decisions will, she concluded, be "conditional on, first, the inflation outlook, second, the dynamics of underlying inflation and third, the strength of policy transmission".

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