Lagarde says ‘disinflation process is at work’

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European Central Bank president Christine Lagarde said rapid wage growth was already showing signs of slowing in the eurozone, striking a dovish note on the potential for interest rate cuts even as the central bank kept monetary policy on hold.

“The disinflation process is at work,” the central banker said at a press conference after the ECB kept its key interest rate on hold at a record high of 4 per cent and signalled inflation was falling in line with its expectations.

Lagarde said a pick-up in inflation in December had been “weaker than expected” and forecast that price pressures would “ease further over the course of the year”.

While rapid wage growth and lower productivity were “keeping price pressures high”, she said there had already been a slight decline in wage growth that was “directionally good from our perspective”. Lower profit margins suggested companies were absorbing increased labour costs rather than passing them on to consumers by raising prices.

Lagarde outlined both upside and downside risks to inflation, but said it could “decline more quickly in the near term” if energy prices continued to drop in line with lower market expectations for oil and gas prices.

The ECB was observing the supply chain disruption caused by the conflict in the Middle East “very carefully”, Lagarde said, adding: “Shipping costs are increasing and delivery delays are increasing.”

The euro fell after Lagarde spoke, slipping 0.5 per cent against the dollar to $1.0833, as investors judged her comments to have opened the door to a potential rate cut in April. Germany’s two-year bond yield fell 0.09 percentage points to 2.62 per cent.

Investors have been watching for clues from central bankers on how fast inflation is likely to fall and when borrowing costs could start to be lowered.

Dirk Schumacher, a former ECB economist now at French bank Natixis, said her comments were “slightly more dovish than expected” but he still thought the ECB was unlikely to cut rates before June.

“Given the focus on wages and how they have put this so prominently in the shop window, I don’t think they can cut without evidence of at least a moderation of wage growth, which they won’t have before June.”

Lagarde said there had been a consensus among ECB rate-setters that it was “premature to discuss rate cuts”. But she also stuck to her comments last week that such a move was “likely” in or by the summer, saying: “We need to be further along in the disinflation process” before being confident inflation will fall to the ECB’s 2 per cent target.

Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said another “downside surprise” to core inflation could push the ECB to cut rates before the summer.

Western central banks are becoming more confident they could soon start cutting interest rates as inflation falls closer to their targets. But they are weighing the risk of a resurgence in price pressures if they lower borrowing costs too early against the danger of doing unnecessary damage to growth and jobs by waiting longer than needed.

Rate-setters in Japan, Canada and Norway also left policy unchanged this week, with similar outcomes expected from the US Federal Reserve and the Bank of England next week.

Economists have already cut their forecasts for eurozone growth and inflation this year after weak data on industrial production, producer prices, business orders and retail sales pointed to a slowing economy. Lagarde said the bloc’s economy was “likely to have stagnated” in the fourth quarter and recent data “signal weakness” at the start of this year.

Yet some still worry high wage growth and supply chain disruption caused by attacks on ships in the Red Sea may keep inflation high. Eurozone inflation is expected to fall from 2.9 per cent in December to 2.7 per cent in January when updated price data is released next week, according to Barclays’ forecasts.

The gloomy outlook for the eurozone economy was underlined by the Ifo Institute’s closely watched survey of German companies. Its business climate index unexpectedly fell 1.1 points to 85.2, its lowest level since shortly after the pandemic hit in May 2020. Economists polled by Reuters had forecast an increase to 86.7.

Additional reporting by Mary McDougall