ECB keeps rates high, despite flagging economy

Despite wages barely having contributed to inflation over the past years, European Central Bank (ECB) president Christine Lagarde warned against lowering interest rates too soon because wages might drive up inflation again later this year.

“Wages are expected to become an increasingly dominant driver of inflation,” she said during a monetary policy dialogue with the European Parliament in Brussels on Thursday (15 February).

Inflation in the EU is set to decline from a steep 6.3 percent last year to 2.7 percent this year and in 2025 only slightly above the bank’s baseline target of 2.2 percent.

In an economic ‘winter forecast’ also published on Thursday, the European Commission downgraded EU growth forecasts for 2024 to 0.8 percent, from 1.2 percent in the autumn forecast, as high interest rates weigh on economic activity.

“The rebound expected in 2024 is set to be more modest than projected three months ago,” said EU economy commissioner Paolo Gentiloni.

When presenting the ‘autumn forecast’ last year, Gentiloni had already indicated that interest rates have taken a “a heavier toll” on the eurozone economy “than previously expected.”

In part because of worsening economic prospects, rate watchers are betting that the ECB will start lowering interest rates this year, possibly as early as April or most likely in June, from the current record high of 4 percent.

But Lagarde refused to commit to a date on Thursday.

“We do not have enough evidence yet that we are going to hit our 2 percent target and that it will remain there,” she said, adding: “The last thing I want is us making a hasty decision to then see inflation rise again.”

The focus on the potential inflationary risk of wages is striking as the ECB’s own research suggests inflation in the eurozone is largely driven by supply disruptions in energy and food, and have little to do with demand or wages.

Some “80 percent of the ECB’s mistakes on inflation projections had to do with energy prices,” Lagarde said on Thursday.

Risk of rates

Meanwhile, keeping rates high is not without risks of its own.

At the end of January, the German Federal Statistics Office reported the country’s economy had shrunk by 0.3 percent in 2023, in part due to high interest rates dampening investments.

Furthermore, according to the ECB’s latest financial stability review published late last year, loan defaults and late payments of home buyers are on the rise due to higher mortgage costs, and some banks are showing “early signs of stress.”

This however will be compensated for in the meantime as the ECB pays banks’ higher interest rates over their deposits than commercial banks pay their customers.

Last year, this resulted in a cash transfer to commercial banks worth €146bn.

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