The euro zone economy is facing exceptional shocks from trade, defence and climate issues, possibly amplifying inflation volatility and raising the risk that price growth becomes more persistent, ECB president Christine Lagarde said on Wednesday.
These forces make it impossible for the ECB to signal policy intent but make it imperative the bank doubles down on its 2 per cent inflation target and outlines how it reacts to various shocks, Lagarde said in a speech in Frankfurt.
The ECB has cut interest rates six times in since June but provided not clear hint about future policy last week, leaving markets guessing an era of particular uncertainty, driven by the Trump administration’s challenge to established international cooperation.
“Our expectations have indeed been swept aside in the last few years, and in the last few weeks in particular,” Ms Lagarde said in a speech. “We have seen political decisions that would have been unthinkable only a few months ago.”
Trade fragmentation is likely to lead to larger, more disruptive price changes and could in principle, much like extra defence spending, lead to higher inflation.
But there similarly a risk that such shocks counteract each other and extinguish price pressures, she argued.
The key issue for the ECB is that inflation reacts disproportionately more strongly to large shocks than small ones, and such large shocks could make inflation more durable.
These disproportionate price reactions, coupled with the current wage setting mechanism, risk creating persistent inflation problems.
“If such state-dependent pricing becomes standard when the economy is hit by large shocks, but the frequency of wage-setting remains below that of price adjustment, we could see inflation becoming more persistent,” Ms Lagarde argued.
“Large shocks would lead to a faster pass-through to inflation, and then wages would have to catch up with prices in a staggered way,” she said.
Lagarde did not offer a solution out of these issues but argued that the ECB must be clear in what it can and cannot do.
The bank cannot promise to keep inflation at 2 per cent all times and cannot give specific guidance about where policy is going.
But the bank must set policy so inflation is always converging towards 2 per cent over the medium term and it must outline its so-called reaction function, so firms and households will always know how a particular shock will impact policy.
“We can be clear about our reaction function, and notably how we are likely to be affected by changing circumstances and what kind of data we will look at,” she said. – Reuters
