Interview with Cinco Días
Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted by Nuño Rodrigo and Laura Salces on 25 May 2022
30 May 2022
What has happened in the ECB’s Governing Council during the past few weeks? This week President Lagarde has signalled a shift from indicating a rate increase some time after the end of asset purchases to two rate hikes by the end of September.
As we have always said, there is a clear sequence. The fulfilment of the conditions to end asset purchases in the third quarter, which starts in July, has become increasingly clear. And the next step sets up the expectation of when to raise rates and what the increases will look like. I think it was important for President Lagarde to lay out a roadmap signalling the end of net asset purchases in July and the end of negative interest rates in September. It is a robust and appropriate decision, although it is too early to know what will happen after that, as it will depend on how the economy evolves.
It is unusual for the President of the ECB to provide such a clear roadmap. Does the ECB feel under pressure to act?
It is important for people to understand our thinking. The two months between the April and June meetings were probably too long not to give any guidance. I think it was very good timing for President Lagarde to lay out a roadmap. The roadmap includes ending quantitative easing at the start of the third quarter and then two rate increases in July and September, so that by the end of the third quarter we have moved out of negative rates. Of course, we have meetings coming up in June, July and September, but given the high uncertainty we’re facing, it is important to set good expectations.
Could there be a 50-basis point hike in the July meeting?
What we see today is that it is appropriate to move out of negative rates by the end of the third quarter, and that the process should be gradual. Normalisation has a natural focus on moving in units of 25 basis points, so increases of 25 basis points in the July and September meetings are a benchmark pace. Any discussion about other moves would have to make the case for moving more strongly than this sequence of hikes in July and September. The discussion will be had, but our current assessment of the situation, where we think the medium-term inflation outlook is in line with our two per cent target, calls for a gradual approach to normalisation.
The current nature of inflation creates a dilemma: some people think the rate hike will come too late, whereas others think it’s not so urgent, as the inflation is driven by the supply side rather than the demand side. What do you think?
Our roadmap is robust and covers a range of different interpretations of what’s going on – on one side, the view that inflation is exclusively due to a supply shock and, on the other, the view of those who believe that there is a big domestic demand component. Moving out of negative rates in September makes sense under either interpretation. This debate will continue in the autumn, and at that point we’ll have more information and will know more about the dynamic of inflation and second-round effects on wages. With more time, we will find out more about the balance between supply and demand, between temporary and longer-term factors. Taking the first steps is appropriate under a range of hypotheses, and we will know more over the coming months about the next steps after that.
Is the depreciation of the euro a factor in the recent update to the roadmap?
There has been a movement against the US dollar but there have also been opposing movements against other currencies, so on a trade-weighted basis the euro has moved much less. But regardless, the exchange rate is very important for the euro area economy and for its exporting firms, including those in Spain. But it would be a mistake to only focus on one of the factors affecting import prices. The exchange rate matters in many ways, so we consider it in our projections, together with all the other factors that are shaping the economy.
Will there be an upward revision to inflation projections and a downward revision to growth expectations in June? The most recent projections were published just two weeks after the start of the war in Ukraine.
The impact of the war is becoming increasingly visible in the European Commission’s recent projections and those of other economic institutions. In the near term, directionally, there is an upward pressure on inflation and a negative impact on growth. But for monetary policy, how we assess the medium term is very important, so not only 2022 but also 2023 and 2024. We need to go beyond the immediate impact and analyse the medium-term effects of factors like high prices today leading to lower incomes and lower demand.
Are we now closer to the adverse inflation scenario that you talked about in March – of 7.1 per cent this year?
I don’t think that’s the way to look at it. The baseline scenario changes with each set of quarterly projections. In June we will have an updated baseline, which will reflect all the factors that affect the economy. We take into account the uncertainty created by the war, which is weighing on GDP, as well as the recovery from the pandemic. It’s important to remember that all the factors are at work, rather than just focusing on one element.
Is there a risk of recession in 2023 or later? The ECB is going to raise rates, and this risks damaging growth.
The European Commission has already significantly downgraded growth for this year. But because of the recovery from the pandemic, there is a natural momentum in the economy. The euro area economy is still projected to grow, although at a slower rate than was expected. Even without a recession the war is having a sizeable impact on the euro area. In any case, we are moving towards a normalisation of monetary policies that were introduced to fight excessively-low inflation. It is more a withdrawal of stimulus than a monetary tightening. Monetary policy is still going to be supportive. Moving out of negative rates in September does not mean that interest rates are going to be high – these are still going to be relatively supportive. It’s a pathway to normalisation.
What would be the neutral interest rate for the eurozone?
The ECB would look at this, of course, like many others. There are calculations of the equilibrium real interest rates. As you can see in previous speeches I have given, but also others, these are projected to be very low, negative in many calculations and around zero in others. I appreciate that investors want to predict where the neutral interest rate will be, but for us as a central bank the important focus is on a pathway where essentially we will be moving rates and then we’ll be simultaneously assessing the inflation dynamic. Rates will settle down when inflation settles around two per cent, and we should be open-minded where that will be. We’re going meeting by meeting, quarter by quarter. As President Lagarde has said, we can move more quickly if inflation pressures are high and more slowly if there are downside risks to inflation. So that’s our focus, not the academic debate on where the so-called neutral interest rate is. And if you look at the history of monetary policy, this approach reflects a more normal monetary policy situation.
Sovereign bond yields are rising rapidly, and risk premia too. Is there reason to be worried about the risk of financial fragmentation?
In December we essentially started normalisation by confirming that net purchases under the pandemic emergency purchase programme (PEPP) would end in March. And we were already explicit at the time that we would be flexible in our monetary policy in the future. We are not going to ignore fragmentation risk – clearly, we know it is something that was very damaging in the past. We are monitoring fragmentation risk continuously and, within our mandate, we are committed to preventing it.
In 2012 Mario Draghi wasn’t talking about fragmentation but about redenomination risk. The yields of Spanish and Italian bonds were very different to what they are now but, in terms of market fragmentation, where is the pain threshold?
I think the pain threshold in terms of risk premia has to be evaluated in the particular circumstances we find ourselves in. It’s not as simple as giving a fixed number at which point we would intervene. We have to always be monitoring what is going on, assessing the sources of movements in yields and the basis for intervention.
Does the ECB need a contingency tool to address this risk of financial fragmentation? Or can you address it just by adjusting the PEPP reinvestments?
In the last Governing Council meeting we said that we stand ready to adjust all of our instruments within our mandate, incorporating flexibility if warranted, to ensure that inflation stabilises at our two per cent target over the medium term. Flexibility is a general concept. One application is through the PEPP reinvestments, but there are also other instruments that could be used. The debate about what type of instrument could be used is a secondary one – the bottom line is the commitment that we will not let unwarranted impairment of the transmission mechanism interfere with monetary policy and our ability to deliver our target.
Spain and Italy are among the most vulnerable countries in the euro area. Are we prepared to weather higher financing costs?
The Spanish and Italian economies are stronger than they were ten years ago. There has been a very significant recovery. Over the medium term it’s difficult to overstate the impact of the Next Generation EU funds, which will be a very important anchor for economic activity. Another recovery path is through the normalisation of tourism, and here Spain and Italy will be among the countries that benefit the most. Also, across Europe, we are not witnessing the very severe imbalances seen during the financial crisis. We also talked about the equilibrium interest rate. The market is not expecting interest rates to return anywhere near those levels that were problematic in that period.
What do you think of the suspension of the fiscal rules for this year and 2023?
The European Commission’s baseline scenario is that the euro area economy will be growing this year and next. But there are risks that the situation might deteriorate owing to the war, and so it makes sense for the escape clause to be extended for another year. This does not mean that fiscal policy should be loosened – it’s more a question of risk management. And remember that many programmes that were launched during the pandemic are now finishing and tax revenue is expected to recover, which should lead to an improvement in fiscal positions.
When the war is over and the uncertainty fades, we will have to make sure that there is a clear framework to reduce debt ratios gradually. By and large, fiscal policy should be moving towards a neutral setting under the baseline.
Just like monetary policy?
Yes, essentially. Many private sector activities were restricted during the pandemic, and these should be recovering now. We are in a world where fiscal policy can step back a little bit.
You mentioned some tailwinds, especially for the Spanish economy, like tourism and the Next Generation EU funds. What are the headwinds that the ECB is working against?
Internally, the energy shock is a big challenge for Europe, which imports a lot of energy. Collectively, Europe has less disposable income, and that means lower demand for many sectors. And externally, the uncertainty about the evolution of the world economy and the war in Ukraine is a risk factor.
Crypto-assets have undergone a severe correction, a drop which comes at the same time as the ECB’s warnings about their correlation with the financial sector. How big is the threat to financial stability?
The assessment is that the European financial system is not overexposed to cryptocurrencies. But we should prepare, and that’s why having regulation and providing more information to consumers is important. The sharp fall in crypto-assets is a wake-up call for many investors who had speculated in some of these products and experienced significant losses.
What are your greatest concerns about crypto-assets?
Our diagnosis is essentially that everything that has happened recently is due to pure speculation. What we have now are new technologies, which may be promising but highly volatile in a world with no regulation. We need to develop good regulation for digital finance. A digital euro, issued by a central bank, would allow many of these technologies to play a very beneficial and regulated role.
Could what has happened with digital assets harm the development of the digital euro?
No, I don’t think so. These are different concepts. The narrative that a private sector invention can replace the official currency of a state just doesn’t hold up. The digital euro would be one-to-one with cash and with money in the commercial banking system, which is entirely different to some kind of engineered product that relies on some algorithm or imperfect mechanism.
What’s the time frame for the digital euro?
We’re in an investigation phase now, but it’s a process that could take around five years. A clearer roadmap, which we should have sooner rather than later, will be helpful for everyone involved in the project. We have to make the right decisions, and this also involves the European Commission and the Member States.
The pandemic and now the war in Ukraine are causing huge changes in the economic and geopolitical landscape. How do you think the euro area is prepared for this new world?
Having a single currency is extremely beneficial. It’s a very effective way of dealing with these global shocks, and very different to each country having to cope with the pandemic or the war in Ukraine by itself. Europeans appreciate that it’s important to have a common currency and to take collective decisions. Europe should be able to make its own decisions. And the ECB can deliver this. Thanks to the euro, we have a great deal of control to deliver price stability and to contribute to the objectives of the European Union.
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