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The European Central Bank’s president has warned of the risk of a “tit-for-tat dynamic” between companies and workers that pushes up profit margins and wages, increasing price pressures as both groups try to avoid a hit from higher inflation.

Christine Lagarde said on Wednesday that the ECB’s recent increases in borrowing costs were “only starting to take effect now”, and signs that inflation was persisting at high levels meant it had to “bring rates to sufficiently restrictive levels to dampen demand”.

The recent banking turmoil has sowed doubts over what happens to inflation, raising fears of a credit crunch that would weigh on demand and, eventually, prices. But Lagarde listed other reasons why it was likely to be harder for the ECB to lower prices pressures without raising rates above their current level of 3 per cent.

“Inflation is still high, and uncertainty around its path ahead has increased,” Lagarde told the ECB and its watchers conference in Frankfurt. “This makes a robust strategy going forward essential.”

“So far, we do not see clear evidence that underlying inflation is trending downwards,” she said. “In fact, we see two forces pushing underlying inflation in different directions.” Lower energy prices are pushing inflation down but buoyant domestic demand is offsetting this, as companies increase profit margins and workers push for higher wages in tight labour markets.

The euro climbed after Lagarde spoke, rising 0.3 per cent to a five-week high against the dollar of $1.080.

Krishna Guha, head of policy and central bank strategy at US investment bank Evercore ISI, said Lagarde’s comments “indicate a bit more confidence” that banking turmoil will not disrupt plans to raise rates.

Her comments chimed with a warning from Joachim Nagel, head of Germany’s central bank, who told the Financial Times that eurozone rate-setters must be “stubborn” and continue raising rates to tackle inflation.

Echoing this, Germany’s economic council warned on Wednesday that financial market instability could undermine efforts by central banks to fight inflation, as it predicted price growth of 6.6 per cent for Germany in 2023.

“The high degree of uncertainty in financial markets that we’ve seen in the past few weeks is making it harder for central banks to fight inflation,” said Ulrike Malmendier, one of the members of the council, which advises the German government on economic policy.

Lagarde called for a “fair burden sharing” between workers and companies to distribute the losses caused by higher inflation, which she said would bring wages and price pressures down. But if both groups “attempt to unilaterally minimise their losses” it could push up profit margins, wage growth and prices all at once.

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

The ECB president said its main power to bring down inflation by raising interest rates could be diluted by a number of factors. These include banks’ reluctance to pass on higher rates to savers, the build-up of €900bn of excess savings since the coronavirus pandemic hit three years ago, an extra €250bn of fiscal support from governments last year and again this year, and a lower level of variable-rate mortgages.

The ECB will “monitor carefully” whether banks start to apply a larger “intermediation wedge” to the cost of credit to demand higher compensation for increased risks, she said. If this happens the “pass-through” from higher rates to lower demand and prices would “become stronger”.

Lagarde reiterated that there was “more ground to cover” for the ECB in raising rates if it maintained its forecasts showing inflation would remain higher than its 2 per cent target for the next three years.

But she added that banking tensions had “added new downside risks and have made the risk assessment blurrier”.

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