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European Central Bank president Christine Lagarde said the ECB was becoming less able to guarantee meeting its 2 per cent inflation target in the short term, as policymakers were forced to wrestle with “exceptionally high” uncertainty.
A week after the central bank signalled a possible slowdown in cuts to borrowing costs, after reducing its benchmark interest rate for the sixth time by a quarter point to 2.5 per cent, Lagarde told a conference in Frankfurt that the environment had become so difficult that it would be “impossible” to guarantee that “headline inflation will always be at 2 per cent”.
The comments will fuel doubts over the pace and frequency of potential future rate cuts, after Lagarde withdrew her previous guidance that “the direction of travel” — further gradual cuts — was “clear”.
That change in tone from the ECB president reduced expectations of another rate cut in April, with several banks now expecting that rates will be cut less by the end of the year than previously forecast.
The ECB’s 2 per cent inflation target — introduced in 2021 — covers the medium term and allows for short-term deviations in real time trends.
Lagarde stressed that the goal was to ensure that “inflation is always converging back towards 2 per cent over the medium term”. This orientation “enables us to avoid reacting to small or passing shocks that will have faded by the time the effects of a policy change kick in”, she said, adding that the ECB could “adjust the horizon within which we must return inflation to target”.
The ECB president warned that higher public borrowing to fund defence and infrastructure investment, as well as a potential trade war involving the US, “might feed into inflation more directly and increase volatility”.
The euro area might be particularly vulnerable as it was “highly exposed to some of the new types of shock” because of its large dependence on global trade and energy imports, she said.
Escalating tariffs, as well as a debt-funded push to raise defence and infrastructure spending by Germany and other euro countries, could create “new, two-sided shocks” that could either damp or accelerate inflation, according to Lagarde.
“The direction of shocks is much harder to predict,” she said.
As a consequence, the ECB would pay even closer attention to inflation expectations. Lagarde said the central bank could “look through” short-term supply shocks such as higher energy prices as long as households and companies do not take higher price increases in the future for granted.
But inflation expectations may have become more volatile following the recent price surge. “Once consumers took notice of rising inflation, their inflation perceptions responded quickly but reduced more sluggishly when inflation started to fall,” Lagarde said.
On interest rates, she said the ECB “cannot provide certainty” about the path forward. It would instead look to clarify how it would respond to particular shocks and events.
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