Interview with Expresso
Interview with Luis de Guindos, Vice-President of the ECB, conducted by João Silvestre on 9 September
16 September 2022
After the policy rate was increased by 0.75 percentage points last week, Christine Lagarde said that “we are so far away from the rate that will help us return inflation to 2%”. Does that mean that we could have another 75 basis point rise at the meeting in October, as markets already seem to anticipate?
It is very hard to understand our decisions without looking at the projections, which have just been updated and contain different scenarios – the baseline and the downside scenarios. Inflation is very high – the latest figure is 9.1% for the euro area – and our projections indicate that it will continue to be high for the rest of the year. It is going to decline eventually but still remain above our 2% target over the medium term. In 2024, inflation is projected to be 2.3% on average in the euro area.
Inflation is the main factor that we have to focus on, as we did when we decided to increase rates by 75 basis points. Uncertainty is very high. We will be data-dependent and follow a meeting-by-meeting approach to set interest rates. We will not make any precommitments. We want to be flexible and have leeway in our decision-making.
When Christine Lagarde said that we are still so far away from the interest rate level that is necessary to bring inflation down, does that mean that we should reach that rate faster, or that the interest rate level should be higher?
The reality is that inflation is currently 9.1% and our target is 2% over the medium term. There is a big difference. That is why we started normalising our monetary policy. Within the Governing Council we do not have any estimates of the terminal rate – the maximum level to which rates could rise – or the neutral rate – the rate that balances the economy at full employment with stable inflation. We have not decided anything. But, as the President indicated, more hikes might come in the next few months – how many times and by how much will depend fundamentally on the data – and we underscore our full determination to make inflation converge towards our definition of price stability.
When do you think we could have inflation back at 2% again?
According to our projections, in 2024 we will be a little above our target with average inflation of 2.3% in the euro area. In the downside scenario, which incorporates a total cut-off of gas deliveries by Russia, the rate would be 2.7%. That is rather high. We expect that inflation will start to decline to an average of 5.5% in 2023, which is still a lot. There is a high level of uncertainty and how the Russian invasion of Ukraine evolves will also play a key role. This is why we want to keep flexibility as ample as possible in order to be able to react to this kind of situation.
Some critics say the ECB was slow to react to rising inflation. What is your answer to those critics, given that, as you said, inflation is well above the target of 2%?
We started the process of monetary policy normalisation in December when we decided to set an end date for our asset purchase programmes: the pandemic emergency purchase programme (PEPP) and the asset purchase programme (APP). The projections over the last 12 months have underestimated the evolution of inflation. This happened not only at the ECB, but also in other international institutions. The pandemic was a big disruption to the normal functioning of the economy, as were other events that were difficult to anticipate, like the war in Ukraine. Once we corrected the gap between forecasts and reality, we reacted. Now it is important to look forward. We have a much better understanding of the drivers of inflation, the interplay between supply and demand factors, and the need to avoid second-round effects. It is key for us to keep inflation expectations anchored and under control.
Is the ECB now on the correct path to control inflation?
Monetary policy is an instrument that produces its effects with a certain lag. Depending on the country and the monetary policy transmission mechanism, it could take between 12 and 24 months. But inflation expectations are something that we can influence very rapidly. Therefore, what is important is the signals that we are sending. First, that the ECB is fully committed to reducing inflation in line with our 2% target over the medium term and, second, that we should avoid second-round effects on inflation.
Is the unanimity in the decision last week a signal that at the ECB you are now all pulling in the same direction and share the concern about the current level of inflation?
There are 25 of us in the Governing Council of the ECB. There are always differing views. But at the end of the day, we all approved the 75 basis point increase. There is a unanimous position with respect to the need to maintain our credibility and commitment to reduce inflation in line with our target.
The downside scenario of the ECB’s projections points to a recession in the euro area in 2023. How likely is this scenario?
The downside scenario assumes a total cut-off of the supply of oil and gas to the euro area, a protracted war in Ukraine and additional uncertainty. This is the main difference compared with the baseline scenario, which signals the currently high level of uncertainty. The downside scenario results in a recession of -0.9% with inflation close to 7% in 2023. It is a very tough scenario for the euro area. While the situation we have now is difficult, should the downside scenario materialise, it would be considerably worse for families and firms.
Does the possibility of a recession constrain monetary policy or, given the current high level of inflation, does the ECB have no other option but to raise interest rates quickly?
The slowdown of the economy is not going to “take care” of inflation on its own. We need to continue the normalisation of monetary policy. This is something everyone has to understand. The forces that are behind the economic slowdown are very similar to those pushing inflation higher. We have a supply shock that is lowering growth and simultaneously raising inflation. What we want to avoid is the sort of situation that we had in the 1970s, which also started with an energy shock followed by second-round effects that made things much worse. The world economy is in a different situation now, but this is something we have to take into consideration. Let me be very clear: the slowdown of the economy will reduce demand pressures, which will lower inflation. But, simultaneously, we have to act from the monetary policy standpoint to keep inflation expectations anchored and avoid second-round effects.
The Chair of the Federal Reserve System of the United States, Jerome Powell, recently said that monetary tightening may bring some pain to households and businesses. Is this also inevitable in the euro area? Is it the price we must pay to tackle inflation?
The level of inflation that we have now in Europe is undeniably already causing pain. In my view, Jerome Powell’s message is that we will have to take decisions to reduce inflation that might be painful in the short and medium term, but that will be positive for our citizens in the long run.
President Lagarde has called on governments not to adopt measures that will fuel inflation. But many countries are taking measures to help households and businesses deal with energy prices and inflation. Is there a risk that fiscal policy may end up having the opposite effect to the intended monetary policy effect?
Fiscal policy is in the hands of governments and the European Commission, not of the ECB. Our assessment of fiscal policy is quite clear: it should be selective, targeted and temporary. We know that inflation is causing a lot of pain, particularly for low-income households. This is why it is really important that fiscal policy plays a role in alleviating the pain inflicted by inflation on these vulnerable groups. The ECB welcomes such measures. But expansionary fiscal policy should not happen.
There is another issue that has to do with the energy shock, which has generated some debate among economists. That is whether or not these measures to reduce energy prices actually end up increasing demand, which is the opposite of what they are trying to achieve. I think that reducing demand for energy in Europe is the best tool to reduce Europe’s dependence on Russia.
Is fragmentation still a risk or is it no longer a problem following the announcement of the transmission protection instrument and the reinvestment of redemptions from maturing securities?
So far, we have not seen major signs of fragmentation in Europe. Spreads are under control as we go through the process of monetary policy normalisation and yield curves are moving upwards. Fragmentation is something that we are going to fight because it impairs the transmission of our monetary policy decisions. This is a unanimous position taken by the entire Governing Council of the ECB. For this, we have two instruments. The first one is the flexibility introduced in the reinvestment of redemptions under the PEPP that is being used now. Second, we have the transmission protection instrument (TPI) that will enable purchases of bonds in jurisdictions with deteriorating financing conditions not justified by country-specific fundamentals. With these two instruments we are sending a very clear signal that we will not allow unjustified, unwarranted disorderly movements in sovereign bond markets should this pose a threat to the transmission of monetary policy.
Is the transmission protection instrument ready to be used if necessary?
Sure. We are ready to use it.
How does the ECB decide when a yield has deviated from the norm?
We have a whole range of indicators and different elements relating to financing conditions in countries, not just government bonds, that can help us understand when yields are justified or not. But there will be no automatic response, the Governing Council’s judgement will always be required.
The Portuguese Government has taken a very cautious approach in responding to inflation this year owing to the very high debt-to-GDP ratio. Some believe it should spend more. Do you agree with the Portuguese Government’s approach?
The Portuguese economy has recovered well, surpassing pre-pandemic levels earlier this year. The growth rate was expected at 6.3% this year and 2.6% in 2023 in our June projections. I would expect these figures to have come down a little given the overall deterioration of the economy. But the Portuguese economy shows overall robustness, with an unemployment rate below the euro area average. In that respect, I think that the outlook for the Portuguese economy is better than for other countries. When we look at fiscal policy indicators, government debt levels are high, but from a deficit standpoint (nominal and structural), the indicators are quite positive. The figures are very good, although this is partly due to inflation helping to increase revenues this year. I can’t comment on the political decisions of any country. However, in my view, Portugal’s fiscal policy is prudent and sensible. It creates leeway to support the groups hit hardest by inflation and the slowdown of the economy.
Do you think that monetary policy tightening will put pressure on the banking sector?
I think that we should not take the tightening of monetary policy as a single factor. The increase in interest rates is positive for the margins of European banks, including Portuguese banks. But, at the same time, we have to remember that the increase in interest rates will also affect banks’ funding costs. Also, we cannot overlook the fact that there is a slowdown of the economy, which will give rise to asset impairment and more defaults. The starting position of European and Portuguese banks is good in terms of capital and liquidity, but we should not fall into the delusion of believing that the increase in interest rates will solve the profitability problem of European and Portuguese banks.
How concerned is the ECB about the euro’s current exchange rate?
We do not target the exchange rate, but it is something we look at very carefully. The depreciation of the euro has had a negative impact on the cost of energy in euro. Further depreciation of the euro could be detrimental to inflationary pressures. On the contrary, if the euro stopped depreciating, this could be positive and support the fight against inflation. I hope that the recent depreciation trend is reversed in the near future.