Christine Lagarde emphasizes the need for the ECB to continue increasing interest rates to prevent wage-price spiral

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In order to address the potential impact of tight labor markets and a significant increase in eurozone wages on inflation, Christine Lagarde has emphasized the need for the European Central Bank (ECB) to implement consistent interest rate hikes.

During the annual conference in Sintra, Portugal, Lagarde, the President of the ECB, highlighted that the eurozone has experienced multiple inflationary shocks since the pandemic’s end. By raising its benchmark interest rate from -0.5% to 3.5% this month, the ECB has made significant progress in addressing high inflation. However, Lagarde stated that victory cannot be claimed just yet.

Lagarde explained that the initial phase of inflation, where supply shock costs were passed on to consumers, is fading. Nevertheless, a second phase driven by increasing labor costs is emerging, with projections indicating a 14% climb in eurozone wages by 2025.

Uncertainty regarding the effects of these factors on prices makes it difficult for the ECB to predict when borrowing costs will peak. Despite this, a further quarter-point increase in rates is highly likely in July. Lagarde clarified that she did not intend to signal any future decisions but aimed to frame the challenges monetary policy will face in the upcoming period.

As shortages of skilled labor become more pronounced, companies are holding onto labor resources, which, in turn, leads to reduced productivity. The rise in wages exceeding output puts upward pressure on inflation. Eurozone unemployment reached a record low of 6.5% in April.

The release of fresh price data on Friday is expected to reveal a drop in annual inflation to 5.6% for June. This figure, although above the ECB’s 2% target, is a decline from the peak of 10.6% in October, mainly due to slower energy and food price increases.

The ECB stated it will continue raising rates until underlying price pressures demonstrate clear signs of decline. Core inflation, excluding energy and food, is forecasted to rise from 5.3% last month to 5.5% this month.

A rise in labor costs is expected to cause a decline in companies’ profit margins, potentially resulting in an inflation rate of nearly 3% in 2025. Lagarde estimated that if companies can mitigate a quarter of these margin losses, inflation will remain at a lower level. However, the longer inflation stays above the target, the greater the risks of wage-price spirals and expectations de-anchoring become.

Due to the unprecedented magnitude and speed of interest rate hikes over the past year, uncertainties remain about when these higher borrowing costs will consistently reduce price pressures.

Lagarde stressed the need for the ECB to commit to maintaining high rates for as long as necessary to ensure inflation decreases. This commitment will prevent expectations of a swift policy reversal and allow the full impact of previous actions to take effect.

Analysts at Goldman Sachs described Lagarde’s comments as “fairly hawkish,” suggesting that there is still some way to go before the ECB reaches its peak rate. They added that the ECB sees weaker growth as the means to decrease inflation, rather than exacerbating the policy trade-off.