Lower borrowing costs risk ‘flare-up’ of inflation, warns ECB policymaker

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Lower borrowing costs could reinvigorate the eurozone’s stagnant economy and cause inflation to “flare up again”, a senior European Central Bank official has warned.

Isabel Schnabel, the most hawkish member of the ECB’s six-person executive board, told the Financial Times that the sharp decline in eurozone inflation reflected the “quick wins of deflation” as supply shocks faded.

But she argued that in the battle to bring inflation down to 2 per cent, the “last mile remains a concern”.

“We must be patient and cautious because we know, also from historical experience, that inflation can flare up again,” she told the FT in an interview for the Economists Exchange series.

Eurozone inflation peaked at 10.6 per cent in October 2022 but had fallen to 2.8 per cent by January. “We have made substantial progress, and that is good news. But we are not there yet,” Schnabel added.

Pointing to signs that commercial lenders are reducing borrowing rates on mortgages in expectation that the ECB will soon start cutting interest rates, Schnabel said: “This is an argument against adjusting the policy stance hastily.”

Investors are betting the ECB will start cutting rates as early as April. But policymakers said it was premature to discuss such a move at their meeting last month. Many have said it would depend on whether wage growth stayed high or causes another round of price rises.

Wages have been rising more than 5 per cent annually on average across the eurozone as workers in the 20 countries that share the euro seek to recapture the purchasing power they lost due to the biggest surge in the cost of living for a generation.

Schnabel said labour costs were also being pushed higher by a “worrying” recent decline in productivity — or output per hour worked — caused by a mix of labour hoarding by businesses, the integration of “less productive workers” into the workforce and increased sick leave.

The “crucial question” was whether companies would try to pass on higher labour costs to consumers by raising prices or absorb them with lower profit margins, she said.

“If demand is held back by restrictive monetary policy, it will be much harder for firms to pass through higher costs to consumers,” she said, adding there was “some evidence that this is happening”.

But she warned this process was “rather protracted and quite uncertain because the economy could pick up more strongly than expected. That could encourage firms to again pass through costs to consumers.”

The average rate on a typical German 10-year mortgage has fallen from almost 3.9 per cent in October 2023 to just over 2.9 per cent this month, according to price comparison website Check24.

There has been a similar trend in France, where the average rate on a 20-year mortgage recently dropped below 4 per cent, after peaking at 4.7 per cent last year, according to online mortgage broker Pretto.

The eurozone economy failed to grow in the fourth quarter after stagnating for most of last year, as rising borrowing costs, high prices and reduced government support measures weighed on activity by households and businesses.

But Schnabel said there were signs of “a turnaround” in economic activity in the latest survey of purchasing managers by S&P Global and in Citigroup’s Economic Surprise index. The EU’s latest survey of services businesses also found their selling price expectations rose for the fourth consecutive month in January, she added.

“That’s why recent incoming data do not allay my concerns that the last mile may be the most difficult one,” she said. “We see sticky services inflation. We see a resilient labour market. At the same time, we see a notable loosening of financial conditions because markets are aggressively pricing the central banks’ pivot. On top of that, recent events in the Red Sea have sparked fears of renewed supply chain disruptions.”

“Taken together, this cautions against adjusting the policy stance soon,” she said.