The ECB’s inflation dilemma: can Lagarde silence her critics again?

Christine Lagarde’s partner has asked her to stop changing jobs, the European Central Bank president likes to joke, because each time she begins a new role a major crisis seems to follow.

Soon after becoming French finance minister in 2007, she found herself handling the global financial crisis for which she eventually won plaudits.

After being appointed head of the IMF in 2011, the eurozone debt crisis escalated. Despite early criticism for siding with German-led austerity policies, she was admired for her calm diplomatic skills and played a key role in finding consensus on the 2012 Greek bailout that saved the euro.

In the three-and-a-half years since she took charge at the ECB, the European economy has been hit by a series of calamities, including the Covid-19 pandemic and Russia’s invasion of Ukraine. But views are mixed on whether she is doing a good job of responding.

The Financial Times has spoken to a dozen current and former members of the ECB’s rate-setting governing council in the past few weeks as well as several economists, financiers and analysts who follow the central bank closely.

Most of them praise Lagarde for rebuilding unity among ECB monetary policymakers and preventing recent economic shocks from spiralling into a financial crisis. But critics complain she lacks economic expertise, was late to react to soaring inflation and should communicate more clearly.

Line chart of Per cent showing The ECB has not raised rates as aggressively as the Fed or the BoE

The US Federal Reserve and Bank of England have also been blamed for letting inflation surge far above their 2 per cent targets to the highest levels since a price spiral caused by the 1970s oil shocks. But the ECB was slower than the Fed or BoE to start raising rates or to withdraw the massive monetary stimulus it deployed for much of the past decade, leaving it more open to attack.

“For an independent institution, achieving its target is a large part of its accountability, so inevitably big misses are an issue even under exceptional circumstances,” says Spyros Andreopoulos, an economist at French bank BNP Paribas who worked for the ECB until 2018. “The jury is still out — the ultimate judgment may depend on whether the ECB will have to engineer a recession to bring inflation down.”

But in a sense, Lagarde is on familiar territory. Ever since she gave up a successful career running US law firm Baker McKenzie to become a government minister in her native France in 2005, she has faced early brickbats before being thrust into centre stage to help defuse a global crisis. Some analysts believe there is sexism behind the carping, especially from investors. “Financial market participants are mostly men,” says one. “That partly explains it.”

The question now is whether Europe’s self-styled problem solver is confronted with a fire that is impossible to extinguish swiftly.

“I don’t think it was me who caused the crises,” she joked during a recent discussion with students of the elite École Polytechnique in Paris, remembering how rivals stopped calling for her to quit as French finance minister once Lehman Brothers collapsed in September 2008. “It is quite common that when the situation is very complicated, we’re not unhappy to give the reins to a woman.”

Playing catch-up

At the ECB, people close to Lagarde say she is determined to prove doubters wrong by taming inflation and putting the eurozone economy back on an even keel. Lagarde could not comment for this story because the ECB meets this week and officials avoid making public remarks that could influence expectations of monetary policy decisions.

She can seem dissatisfied at the bank. Having struggled to master German since arriving in Frankfurt, which was partly locked down because of the pandemic during her first two years there, she often spends free time with her family back home in France.

Lagarde also misses Washington. She enjoyed her globetrotting job at the IMF more than her new role at the ECB and she thinks of the US capital as a second home after spending a year there as a teenager on an American Field Service student exchange.

“The IMF misses her and I think she misses the IMF,” says a senior financier who has known Lagarde since she was based in the US and recently had lunch with her at the ECB’s still half-empty twin-tower headquarters in Germany’s financial centre. “She seems lonely, sitting up there in that big, gloomy tower with hardly anyone around.”

Insiders say Lagarde regrets relying for too long on the ECB’s forecasting models showing inflation was “transitory” and would soon fall back to its target. She also wishes it had ditched the constraints of the “forward guidance” put in place by her predecessor Mario Draghi, which delayed rate rises until the central bank stopped buying more bonds in June 2022.

A waiter wearing a face mask uses a tape measure to measure the distance between tables
A waiter ensures social distancing. Views are mixed over how Lagarde has responded to the economic fallout of the Covid-19 pandemic © Patrick Hertzog/AFP/Getty Images

As a result of these mis-steps, the ECB has decided to rely less on its forecasts, which consistently underestimated how high inflation would rise, and to scrap much of the formal guidance it gave about future policy moves.

Instead it has committed to put more weight on whether underlying prices, excluding energy and food, are slowing and to what degree higher borrowing costs are squeezing bank lending and economic activity, to determine its next rate moves.

These changes mean the ECB has shifted from being one of the world’s most dovish central banks — it was one of only a handful to cut interest rates below zero in the 2010s — to being one of the more hawkish: it is expected to keep raising rates for longer than either the Fed or the BoE.

“The ECB made one of the worst forecasting errors ever on inflation,” says Otmar Issing, the institution’s first chief economist when it was created in 1998. “It was a brutal wake-up call, but since then they have done a U-turn and been catching up quickly. You have to give them credit for that.”

Having dismissed a surge in eurozone consumer prices in late 2021 as a “hump” that would soon pass without the need for rate hikes, Lagarde has adopted a more determined stance since Russian tanks rolled into Ukraine, unleashing an energy crisis and double-digit price rises. This year she called inflation a “monster that we need to knock on the head”. 

The ECB has raised borrowing costs at an unprecedented rate, lifting its deposit rate from minus 0.5 per cent last July to 3 per cent last month. At a meeting in Frankfurt on May 4, its governing council is widely expected to agree on another increase.

Line chart of CPI inflation (annual % change) showing Inflation has started to return to more normal levels

“They were too late to act when the Ukraine war started, energy prices shot up and there was little doubt inflation would become entrenched,” says Maria Demertzis, an economic policy professor at the European University Institute in Florence. “So now they are playing catch-up and cannot back down easily.”

The worry for some analysts is that having been chided for being too slow to react to inflation, the ECB will now raise rates too high. Dovish council members are urging it to move cautiously, warning that its rate rises only act on inflation with a lag of at least a year. “We will only know in six months if we have done enough,” says one.

“Because they have been criticised so much for starting late, and they are only human, they may respond by doing too much,” says Silvia Ardagna, chief European economist at UK bank Barclays. “They don’t have an easy job at all.”

Some analysts think the council will slow the pace of rate rises to a quarter percentage point this week, reflecting growing uncertainty over how quickly inflation will fall. But Isabel Schnabel, the most hawkish member of the ECB’s executive board who has become an influential voice on policy, has said it could stick to a half-point rise if the data supports it.

The size of this week’s move may hinge on figures to be published on Tuesday, showing the path of eurozone inflation in April as well as what banks in the bloc told the ECB about their lending plans in its latest survey of the sector.

The behaviour of banks is being closely watched by central bankers because of the recent turmoil in the sector which triggered the collapse of Silicon Valley Bank in the US and pushed Credit Suisse into the arms of its rival UBS. Eurozone banks have so far proved resilient to the jitters — despite a worrying but shortlived drop in Deutsche Bank shares in late March.

Evacuees cross a destroyed bridge as they flee the city of Irpin, northwest of Kyiv
Lagarde has adopted a more determined stance on rate hikes since Russian tanks rolled into Ukraine, unleashing an energy crisis and double-digit price rises © Dimitar Dilkoff/AFP/Getty Images

But the upheaval is likely to intensify the contraction of credit supply that had already started in response to rising borrowing costs, leading to a record fall in demand for eurozone mortgages in the final months of last year. Economists say this will slow economic activity and lower inflation, reducing the amount of additional rate rises the ECB needs to do.

“After the shock of what has happened, banks are going to be much more cautious today,” says Lorenzo Bini Smaghi, chair of French bank Société Générale and former ECB executive board member. “My concern is that if the ECB keep squeezing the financial system too much it may lead to a credit crunch.”

These concerns are mostly falling on deaf ears among eurozone rate-setters, who pushed ahead with a half-point rate rise in March only a week after Silicon Valley Bank’s collapse and while Credit Suisse was still locked in talks about a rescue deal.

“These banks tend to overplay their own importance and assume we are playing to their tune,” says one ECB council member. “I don’t see these fears persuading us to focus less on fighting inflation.”

The owl’s perspective

This robust attitude reflects Lagarde’s decision to distance herself more from financial markets than her predecessor Draghi, who won plaudits from investors for promising to do “whatever it takes” to save the euro during a debt crisis a decade ago.

“Some of them at the ECB seem to think what happens in financial markets doesn’t really matter,” says Stefan Gerlach, a former deputy governor of the Central Bank of Ireland who is now chief economist at Swiss bank EFG. “But I think they are underestimating this risk and it could end badly.”

Lagarde’s coolness towards financial markets has created a frosty relationship with analysts and investors, who privately moan about her lack of economics training, vague communications and even her tendency to read back official statements in response to questions at press conferences.

The ECB president has been irritated by the barbs, colleagues say. She has pointed out that neither Fed chair Jerome Powell nor BoE governor Andrew Bailey studied economics. While Draghi did an economics doctorate at MIT, Lagarde has watched footage of her predecessor to find that he read at least as much from pre-prepared statements as she does. Some central bank watchers see sexist double standards at work.

Realising she would not be able to dominate debates on monetary policy, Lagarde chose a different leadership style to Draghi. Eschewing the labels of “hawk” or “dove”, she describes herself as an “owl” sitting above the fray to bring rate-setters with diverging positions together around a common policy decision and then explaining it.

Christine Lagarde receives a ceremonial bell from Mario Draghi as she takes over from him as ECB president
Lagarde chose to adopt a different management style at the ECB from her predecessor Mario Draghi © Bernd Kammerer/Getty Images

“Lagarde doesn’t lead in the same way, rather it seems she manages the governing council,” says Erik Nielsen, chief economics adviser at Italian bank UniCredit. “She doesn’t have a preset idea of where to go; she has an exceptionally good political ear, reads the room and manages to bring them to a decision.”

Team spirit was in short supply when Lagarde took over at the ECB. Many council members had publicly attacked the decision to cut rates and restart bond purchases at one of Draghi’s last council meetings.

Council members praise Lagarde’s ability to win broad support for carefully constructed compromises even if they don’t always agree with every element. “Christine Lagarde is doing an excellent job,” Joachim Nagel, head of Germany’s central bank, told the FT recently. “She brings people with different views together to reach good decisions on a common monetary policy.”

To build unity, Lagarde holds a regular call with the heads of the German, French, Italian, Spanish and Dutch central banks to discuss big moves before each policy meeting, while she or her chief economist Philip Lane also contact the 15 other national governors.

However, some council members think her drive for togetherness is concealing subtle shifts in their debate. “Where there is room for discussion is if there is too much consensus,” Pierre Wunsch, head of Belgium’s central bank, tells the FT. “I think it removes relevant information from the market.” 

ECB watchers say this partly explains why Lagarde sometimes surprises the market. “It is harder to communicate with one voice when there is a whole range of views out there,” says Jens Eisenschmidt, chief Europe economist at US bank Morgan Stanley who worked at the ECB until last year. “This makes it harder for the market to know what their next steps are and the precision of communication can suffer.”

Knowing when to stop

The closer the ECB gets to pausing its rate rises, the harder it will be for Lagarde to maintain unity. Already in March, there were a handful of dissenters who worried that raising rates was risky because of the banking turmoil. Its ultimate decision was attacked by both rightwing Italian politicians and left-leaning European trade union officials.

“It was relatively easy to agree on the need to raise rates to current levels, but it will get harder to deliver consensus as you have more cross-currents now,” says Sven Jari Stehn, chief Europe economist at US bank Goldman Sachs.

He expects Lagarde to use a combination of other tools to win support for rate decisions, such as committing to further hikes, promising not to cut them for a period after pausing, or agreeing to speed up the shrinkage of the ECB’s balance sheet.

Line chart of Real GDP (Q4 2019 = 100) showing The post-Covid recovery has been tepid

The eurozone economy expanded 0.1 per cent in the first quarter of the year, weaker than forecast but an improvement from stagnation at the end of 2022. Economists say this rebound, despite last year’s energy shock and the sharp rise in borrowing costs, reflects a build-up of excess savings during the pandemic, a boost from generous government subsidies and the recovery of global trade.

While headline inflation has fallen for five consecutive months since peaking at a eurozone record of 10.6 per cent in October, the resilience of the economy coupled with rising profit margins and wages has kept core price pressures going up after excluding energy and food.

Veteran central bankers sympathise with the ECB’s challenge of deciding when to stop raising rates, which they expect to test Lagarde’s leadership skills to their limits.

“We have a war in Ukraine, globalisation has slowed, supply chains are changing — to mention only a few factors,” says Issing, one of the eurozone’s founding fathers. “It is a situation of great uncertainty, which is very difficult to interpret correctly. There is a risk of overdoing it, but the risk of letting inflation run away is more important.”

Data visualisation by Keith Fray