ECB slashes inflation forecast but holds rates amid mounting analyst worries

The ECB on Thursday (7 March) held interest rates at their current record high levels, despite also slashing its growth and inflation projections for the eurozone, with ECB president Christine Lagarde claiming the bank is not “sufficiently confident” on wage and profit data to begin cutting rates.

The ECB’s widely anticipated decision to leave its key interest rate at 4% for the fourth consecutive occasion came as it cut its inflation forecast for 2024 to 2.3% — 0.4 percentage points below its previous December projection and only fractionally above its 2% target rate.

The central bank also downwardly revised the eurozone’s GDP forecast for this year from 0.8% to just 0.6%, with Lagarde warning that growth could be even lower if there is a “further slowdown in global trade” or if “the effects of monetary policy turn out stronger than expected”.

“We are making good progress toward our inflation target,” Lagarde said, pointing to the fact that inflation has fallen for each of the past three months, from 2.9% in December to 2.6% in February.

“And we are more confident as a result. But are not sufficiently confident. And we clearly need more evidence, more data, and we know that this data will come in the next few months,” she said.

“We will know a little more in April, but we will know a lot more in June,” Lagarde added, confirming widespread market expectations of a first rate cut arriving this summer.

Lagarde further noted that the Governing Council, the ECB’s main decision-making body, is “particularly vigilant” about wage and profit data but stressed that “profits are absorbing part of the rising labour costs, which reduces [their] inflationary effects”.

The ECB hiked rates on ten consecutive occasions between July 2022 and September 2023 in its efforts to curb soaring prices triggered by Russia’s full-scale invasion of Ukraine in February 2022, bringing its benchmark deposit facility rate from -0.5% to 4%. 

The bank kept rates unchanged at its previous three meetings in October, December, and January.

A monetary mystery

Lagarde’s comments come amid a wider debate about the impact of wages and profits on Europe’s inflation crisis over the past two years, as well as a similarly contentious discussion about the effects of recent ECB policy on the broader eurozone economy – which has seen mounting warnings from analysts and trade unions.

In a study published in June last year, the International Monetary Fund (IMF) estimated that corporate profits accounted for 45% of the increase in eurozone inflation over the previous two years, while rising import and labour costs accounted for 40% and 25% of price rises respectively. 

In a remarkably prescient prediction, the fund warned that “companies may have to accept a smaller profit share if inflation is to remain on track to reach [the ECB’s 2% target by 2025]”. 

The fund’s analysis — and prediction — closely aligns with comments delivered by Lagarde at the European Parliament last week.

“Profits are not increasing at the pace where we had seen them increase in the course of 2022 and beginning of 2023,” said Lagarde, who headed the IMF before assuming her current role at the ECB.

“So during the second half of [20]23 profits were contributors to inflation by only 25% whereas in the past it had been 50%… Gradually, because of pressure on demand, we are seeing a reduction of profits because they absorb some of the wage increases.”

Patricia Velicu, a senior policy adviser at industriALL Europe, which represents seven million employees in Europe’s manufacturing, energy, and mining sectors, told Euractiv that the ECB’s and the IMF’s findings that profits are largely responsible for the eurozone’s inflation crisis make the ECB’s tight monetary policy all the more puzzling.

“We don’t really understand why the ECB continues to keep the rates so high, especially because [the] inflation crisis was mainly driven by high corporate profits, very high energy prices, [and] temporary supply chain disruptions,” she told Euractiv.

“It was not really driven by wages. [So] we can have a whole conversation over whether the drop in inflation was actually due to the policy of the ECB because, in our opinion, it wasn’t,” she added.

Carsten Brzeski, an economist at ING bank, told Euractiv that the effect of ECB’s policy on inflation over the past two years is “one of these mysteries that we will never know”.

In his view, however, “a big chunk” of the disinflation witnessed over the past year is “mainly the result of energy base effects” and hence “would probably have occurred without any rate hikes”.

Brzeski also expressed sympathy for the theory espoused by some economists that the health of Europe’s larger banks means that monetary policy may be taking longer than usual to filter through to the wider economy.

“Given that the major European banks are in a better shape than 15 years ago during the financial crisis, this [theory] actually argues in favour of a slower transmission of monetary policy, because the good state of the banks allows them to continue lending, to buffer and absorb the impact from higher rates on the economy,” he said.

“[So] the impact on the real economy could be somewhat slower and more delayed than in the past, because banks are taking longer to pass it through to consumers,” he concluded.

[Edited by Anna Brunetti]

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