Lagarde: Eurozone inflation shock to persist longer than expected

The ECB's second rate hike since the Iran war, which came days before Lagarde spoke, reinforced the case for continued sensitivity to rate changes. With the deposit rate at 2.5% and Bundesbank chief Joachim Nagel flagging the possibility of moving into mildly restrictive territory, markets are likely to keep pricing in a live risk of further tightening rather than an imminent pause. The euro could find some support on the hawkish framing, though the growth risk Lagarde herself acknowledged, alongside upgraded ECB growth forecasts, complicates a simple read on rate expectations. Lagarde also spoke about overvalued AI stocks and the circularity risk among AI companies, which introduces caution for risk assets generally. Still, she emphasized that European banks are more robust now to handle a potential downturn than in earlier cycles.

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The central bank chief stated that the inflation shock stemming from the Iran war is not over, and also cautioned that AI valuations, which are extremely high, might be headed for a correction.

Key points:

• In an interview with Ouest-France, ECB President Christine Lagarde said the inflation shock is more persistent than anticipated, pointing to ongoing Middle East conflict.
• This week, the ECB increased rates for the second time since the Iran war pushed energy costs up, bringing the deposit rate to 2.5%. Chief economist Philip Lane has called that level the upper end of neutral.
• According to Lagarde, energy prices climbed because of the Iran war and reduced refining capacity, especially in Russia. She said the ECB must act because the euro-area economy remains strong.
• Bundesbank chief Joachim Nagel indicated that rates might have to enter mildly restrictive territory to reduce inflation from above 3% to the ECB's 2% goal.
• The ECB's latest forecasts raised inflation expectations for 2027 and 2028, with 2028 now predicted to be a bit above target. Growth projections were also increased.
• Separately, Lagarde called AI valuations very high and said a correction is possible, pointing to a circularity risk: AI firms invest in each other and then grant each other supply contracts. She noted that European banks are better capitalized now than previously.
• Regarding France, Lagarde urged the implementation of planned structural reforms, rejected ideas to cancel central bank-held debt as financially risky, dismissed a presidential run, and said she will leave the ECB next year. She did not say if she will serve until October 2027.

The euro zone's inflation shock will persist beyond what officials had forecast, ECB President Christine Lagarde stated, attributing the ongoing price pressure mainly to the Middle East conflict.

"The current shock is longer lasting," Lagarde said in an interview with Ouest-France published on Saturday. She noted that the Iran war keeps disrupting energy markets, and volatility along with upward pressure on energy prices will probably continue even as higher costs heighten the risk of slower economic growth.

Her remarks came after the ECB raised interest rates for the second time since the Iran war started pushing oil and gas prices up sharply, lifting the deposit rate to 2.5%. Euro-area inflation is currently above 3%, and policymakers think further tightening may be necessary to get price growth back to 2%. Lagarde blamed the rise in energy costs on the Iran war and the loss of global refining capacity, specifically mentioning Russia, and said the combination has raised prices everywhere. The euro area's economic strength, she argued, means the ECB must continue to react.

On Friday, Bundesbank chief Joachim Nagel said rates might have to reach mildly restrictive levels to curb inflation, consistent with the ECB's Thursday projections that showed quicker inflation in 2027 and 2028, with 2028 now forecast a touch above target. Growth outlooks were also raised, indicating the euro area's ability to withstand the Middle East conflict and additional challenges from US trade policy.

Lagarde also discussed overvalued AI stocks in the interview, noting that current pricing is very high and that the upcoming flurry of IPOs in the sector confirms it. She highlighted a circularity risk: AI firms invest in each other and then grant each other contracts for items like microchips. A correction is absolutely possible, she said, without giving a timeframe. She added that European banks have AI-related holdings but are much stronger than in earlier cycles.

Turning to French politics, Lagarde advocated for the implementation of planned structural reforms and again opposed far-left proposals to cancel central bank-held government debt, deeming the idea financially harmful. She downplayed any potential presidential candidacy, calling the notion 'flattering' but improbable, and said she will not re-enter national politics after her ECB term, noting she will soon be 71. Lagarde confirmed she plans to depart the ECB next year but did not specify if that means completing her term until October 2027.