The European Central Bank (ECB) left its benchmark interest rate unchanged at an historically high level of 4.0%. However, the ECB also downwardly revised its forecast for inflation this year, thereby signaling a likelihood that rates will be lowered sometime in the coming months. Christine Lagarde, President of the ECB, said “we are making good progress towards our inflation target and we are more confident as a result. But we are not sufficiently confident. We clearly need more evidence and more data. We will know a little more in April, but we will know a lot more in June.”
In Europe, as in the United States, the biggest obstacle to reducing inflation to the 2.0% target is the labor market. In both Europe and the United States, service price inflation remains elevated. Moreover, services tend to be labor intensive. Thus, the ECB and other central banks are carefully watching labor market conditions. Lagarde said that she would “zero in on and be laser-focused on, to see if there is confirmation of what we are beginning to see, which is moderation on the wage front and an absorption of those higher wage costs by the profit margins.” If wage inflation eases, the ECB would likely be amenable to cutting interest rates sooner rather than later.
Lagarde indicated that the ECB is not yet ready to act but is getting closer. She said “I wish everything was closer to our target, but we are not there yet. I am not saying that we will wait until we see everything at 2.0%.” On the other hand, the Bank for International Settlements (BIS), which is the central banks’ banker, said that the persistence of service price inflation could lead major central banks to keep rates higher for longer.
In response to the ECB announcement, bond yields fell modestly. Investors were evidently not surprised by the action and words. For the ECB, the current situation involves a delicate balancing act. The Eurozone economy is weak, with Germany having been in recession and with growth in other major countries very modest. The longer monetary policy remains tight, the more likely that it will further weaken the economy. Meanwhile, inflation has been declining but is not yet where the ECB wants it to be.