Interview with Verslo žinios
Interview with Luis de Guindos, Vice-President of the ECB, conducted by Dalius Simenas on 10 October 2022
14 October 2022
Some experts are sceptical whether monetary tightening and rapid raising of interest rates are an effective tool to tame inflation, which in the euro area is driven mainly by extremely high energy prices, by Russia's energy blackmail towards those European countries supporting Ukraine against Russian aggression. Are you confident that the European Central Bank (ECB) will manage to curb the record high inflation that reached 10% in September and to get it back to the ECB’s target of 2% over the medium term?
An important part of the inflationary process that we are now facing has been driven by external factors, such as increased energy prices, more expensive raw materials, food, etc. According to our calculations, energy and food prices currently account for two-thirds of inflation in the euro area. However, inflation is also being pushed up by demand for goods and services, as is particularly the case in the Baltic countries. Increased demand can be contained through decisions to normalise monetary policy, while I agree that monetary policy has no influence on energy prices.
Nevertheless, it is very important to avoid second-round effects and prevent inflation being passed on to wages, which would push inflation higher. In order to avoid this, inflation expectations need to remain anchored. Market participants must have confidence in the credibility of the central bank. We will do whatever is necessary to bring inflation back to our 2% target over the medium term.
The OPEC+ alliance, which also includes Russia, recently decided to substantially cut oil production as of November. This has already driven oil prices higher. It is likely that this decision has not made it any easier for the ECB to achieve its goal of bringing inflation down to the target level.
Oil prices are global prices as they depend on producers and the world economic outlook. From an economic perspective, lower oil prices could help reduce inflation and, at the same time, support the economic recovery, thereby facilitating the decisions of policymakers.
What is the state of the euro area economy at the moment?
I think we are going to face a very difficult combination of low economic growth, including the possibility of a technical recession, and high inflation. According to our September projections, inflation will be hovering around 10% until the end of this year and will start to gradually decline in 2023. In this context, monetary policy has to focus on the evolution of inflation, which is what the Governing Council will be looking at when taking decisions. However, the environment will be very challenging and uncertain.
What is your forecast for the euro area’s economic development?
What we considered as our downside scenario in September, is coming closer to the baseline scenario. The current global context, including the monetary policy action, the energy shock and deterioration of the terms of trade, among others, point towards a slowdown of the global economy and, eventually, of the inflation rate as well.
Under the downside scenario from our September projections, the euro area economy would shrink by almost 1% in 2023, while the baseline scenario envisages GDP growth of 0.9%. The difference between the baseline and downside scenarios lies in the evolution of energy supplies from Russia. The assumption under the baseline scenario is that 20% of energy deliveries would continue to be supplied, whereas the downside scenario assumes a total cut-off. Currently, as I have said before, we are getting closer to the downside.
Is it correct that forecast inflation is also higher under the downside scenario?
That’s right. Under the downside scenario, annual inflation is expected to decline from an average rate of 8.4% this year to 6.9% in 2023. Under the baseline scenario, inflation is expected to go down from an average of 8.1% this year to 5.5% in 2023.
Currently the interest rate on the ECB deposit facility is 0.75% in the euro area. What should be the terminal rate to anchor inflation expectations?
That is very difficult to say. We are dependent on the data we receive. There is a very high level of uncertainty. We do not know how the war will develop and what impact it will have on energy prices. All these factors make it very difficult to determine the level of the terminal rate.
We have adopted a prudent stance: our response will depend on how the data evolves in the coming months. In December we will have new projections for inflation and GDP growth that will guide our decisions, despite the high uncertainty.
Historically, average interest rates in advanced economies hovered around 4%. Is this a reality that euro area businesses and mortgage borrowers will face again?
This will depend on various circumstances. Over the last 15 years interest rates have been much lower than that figure and we have had negative interest rates for a long period of time. In my view, structural factors that pushed inflation down in recent times have started to shift. Globalisation is not going to be as intense as it was, and the energy shock can drive inflation higher. So, I think that monetary policy has to adjust to these new structural features that may push inflation upwards when compared to the past decade.
The cost of borrowing for governments has risen dramatically in recent weeks and months. For instance, the Estonian government recently issued ten-year bonds at 4%, despite having among the lowest levels of debt in the euro area. Yields of ten-year government bonds of southern euro area countries fluctuated on average around 3-5%. What is your advice to governments – how should they keep the rising borrowing costs under control?
Fiscal policy has to be supportive of the process of monetary policy normalisation conducted by the ECB. We cannot ignore the fact that inflation is the main problem in the euro area, which is quite obvious in the Baltic countries. Inflation is reducing the purchasing power of households, especially of those that are more vulnerable, and is dampening investment.
Thus, we have to pursue a normalisation of monetary policy. Higher interest rates are needed to try to subdue the rising level of inflation that is clearly above our 2% target over the medium term.
Could you please specify what kind of fiscal policy would be compatible with the anchoring of inflation expectations?
As we are in the process of normalisation of our monetary policy, fiscal policy needs to play a different role than the one played during the pandemic. In the current context, fiscal policy has to be more selective and targeted to support the most vulnerable groups of society. If countries start putting in place indiscriminate measures across the board, the mission of monetary policy will become more challenging and we may be unable to achieve the ultimate goals of reducing dependence on Russian energy and supporting the green transition.
Fiscal policy and monetary policy do not seem to be going hand in hand. The governments of Germany, Lithuania and other euro area countries have chosen the path of subsidising energy prices, which increases their borrowing and budget deficits.
I don’t comment on the policy decisions of any government. But, as a general recommendation, fiscal policy has to be compatible with the process of normalisation of our monetary policy stance. State support has to be temporary and targeted to the most vulnerable groups while facilitating the green transition.
What is your assessment of the policy implemented by the Lithuanian government?
I think that Lithuania is implementing a very prudent fiscal policy. With a public debt ratio of 40% of GDP, Lithuania’s public debt and budget deficit are clearly below the euro area average.
The main problem is inflation, which currently is above 20% – at levels also observed in the other Baltic countries. Disparities in inflation rates among euro area countries will have to be monitored and analysed in detail.