Europe risks a “tit-for-tat dynamic” between workers and employers as each pushes for higher incomes to escape inflation’s bite, Christine Lagarde, president of the European Central Bank (ECB) warned at a German financial conference last week.

The ECB’s recent increases in interest rates are “only starting to take effect now,” she said, and inflation remains high enough—8.5 percent in February—and “uncertainty around its path has increased,” so the bank must “ring rates to sufficiently restrictive levels to damp demand.”

Joachim Nagel, president of Germany’s central bank, echoed her call for additional rate increases, as we report in “Bundesbank Boss Says ECB Must Keep Raising Interest Rates” in this issue.

“This makes a robust strategy going forward essential,” she emphasized. “We do not see clear evidence that underlying inflation is trending downward.”

The ECB has predicted that inflation will remain above its 2-percent target at least through 2025. 

“In fact, we see two forces pushing underlying inflation in different directions,” Lagarde noted: falling energy prices are softening cost pressures, but strong, broad-based consumer demand is driving prices higher.

She called for companies and their employees to share inflation’s burden fairly between them, which will lower price pressures, she predicted.

However, if either group tries to take from the other to ease inflation’s impact on one group at the expense of the other, prices, wages, and business profits could all rise together, Lagarde noted.

“The risk of such a tit-for-tat dynamic is also heightened by the prospect that labor market tightness will linger,” she said.

Lagarde added that the ECB’s power to beat back inflation by raising interest rates has been weakened by €900 billion in extra savings banked during the COVID War that allows consumers to keep spending.

Banks’ reluctance to pay more interest on deposits is another hindrance, she said, as is another quarter-billion euros of public support European governments lavished on businesses and households in 2021 and 2022, largely to pay high energy bills.

TREND FORECAST: With the ECB’s base interest rate at 3 percent and unlikely to rise significantly higher, inflation will persist across the continent for a long time to come. Yet even another quarter-point rate hike will do more to bring down the economy as Europe slides into Dragflation: declining economic growth and rising inflation. (See “Europe Braces for Inflation” 19 Jan 2021).