The European Central Bank president's latest remarks have significantly cooled market bets on further ECB policy tightening.
ECB President Christine Lagarde said on Monday that the notable rise in long-term interest rates will slow economic growth and dampen the pass-through of energy prices into headline inflation, by more than the ECB's September projections estimated. She also stressed that, absent signs of second-round effects, the ECB should take "measured responses" to control inflation.
As a result, traders trimmed their bets on ECB monetary tightening, with the market-implied probability of an ECB rate hike in October now falling below 40%.
Lagarde noted that the ECB's current policy rate is already at the upper end of the range that is neutral for the economy, that is, at the top of the 2% to 2.5% range, but she stressed that the ECB does not use the neutral rate as a reference for monetary policy making.
Meanwhile, escalating tensions in the Middle East pushed oil prices higher, reigniting concerns over the inflation outlook, and investors are now pricing in nearly four more 25-basis-point rate hikes from the ECB over the next year.
Rising Long-Term Rates Substitute for Rate Hikes
Lagarde said that since the ECB's last policy meeting, long-term rates have risen significantly, a trend that will slow economic expansion and suppress inflation pass-through, more forcefully than estimated in the ECB's September projection scenario.
This means that the market's own rise in interest rates is, to some extent, shouldering the function of monetary tightening, giving the ECB room to hold off on action for now.
She reiterated that "interest rate movements do not move in lockstep with energy prices," and that the ECB's policy focus is on whether it can identify the emergence of second-round effects in a forward-looking manner.
Lagarde pointed out that "when second-round effects actually appear, it is already somewhat late," but she also stressed that at present "no signs suggesting second-round effects may emerge" have been observed.
Short-Term Inflation Pressure Persists, AI May Help Lower Long-Term Inflation
Lagarde said that inflation in the euro area is expected to rise further due to the energy crisis, but there is currently little evidence that higher energy costs will intensify broader price pressures in the economy.
Lagarde also noted: "Artificial intelligence has the potential to help businesses increase output, and over time, higher productivity can reduce costs. All else being equal, in the long run, this should reduce inflationary pressure."
Data due this week are expected to show that euro area inflation jumped to 3.7% in September from 3.2% in August, far exceeding the 2% policy target. At the same time, consumers' expectations for future price increases rose again last month.
The Middle East conflict continues, and hopes for a short-term easing of the situation have faded, pushing oil prices higher on Monday and rekindling concerns about rising inflation.
Investors now expect the ECB's deposit rate to be raised by a cumulative nearly 100 basis points over the next year, adding to the two rate hikes already delivered. If this rate hike path materializes, borrowing costs will reach a level that substantially restrains economic activity.
Fiscal Policy in the Spotlight as ECB Calls for Targeted and Measured Support Measures
On the fiscal policy front, Lagarde once again criticized the way governments are responding to rising energy prices.
She said fiscal support measures should be temporary and precisely targeted at the households and businesses that need help most, but the reality falls short of that.
"From the observations of the European Commission and our own, these measures are not necessarily temporary, nor necessarily precisely targeted," Lagarde said. "They are 'one-size-fits-all' measures that do not particularly focus on the most vulnerable and most exposed groups."
Her remarks continue the ECB's long-standing focus on fiscal policy discipline, especially against the backdrop of a sharp bond market selloff that has already put pressure on some euro area member states with fragile fiscal positions.
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