Interview with Milano Finanza
Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted by Francesco Ninfole
6 December 2022
Has the euro zone reached peak inflation?
It’s probably too early to make that judgement, but I would be reasonably confident in saying that it is likely we are close to peak inflation. But whether this already is the peak or whether it will arrive at the start of 2023, is still uncertain. The main uncertainty is that we’ve seen so much volatility in gas prices. In some countries, consumer prices have moved a lot, while in others for example some utility companies have not yet finished hiking prices. Given the significant increase in prices, I don’t rule out some extra inflation early next year. Once we are past the initial months of 2023, later on in 2023 – in the spring or summer – we should see a sizeable drop in the inflation rate. That said, the journey of inflation from the current very high levels back to 2% will take time.
Next year, will inflation go down to 6-7%?
The initial downshift from the current high rates will be to around that level but I would expect further reductions throughout next year.
Is it possible that core inflation will go up while headline inflation goes down?
This could happen, because a big driver of core inflation at the moment is the fact that many sectors across the economy, such as transportation and tourism, use a lot of energy, so when there is a high increase in their energy costs, they have to raise the prices of the services and goods they sell, and then core inflation rises. A second factor has also been the recovery in demand in the last six months, since the lifting of the pandemic restrictions. However, this second factor should play only a minor role next year, when the reopening phase of the economy is over and expenditure settles back into a more normal pattern. A third factor is that wages will be increasing, adding to costs across the economy.
As regards the medium-term prospects for inflation, the ECB has predicted an inflation level of 2.3% in 2024. Will inflation be closer to 2% in 2025, and in the medium term, when most of the pandemic and war-related factors have faded away, will there be more of an upside or downside risk to inflation?
Typically, you could expect inflation to get closer to our target with extra time. One reason is that we have raised interest rates already by quite a bit and we’ve said we’ll raise them again. This does not have an immediate effect on inflation, but over the next one or two years those higher interest rates will dampen demand, reduce expenditure, and therefore reduce the ability of firms to charge high prices and in turn limit the scope of unsustainable wage increases. So a basic reason why inflation will be closer to our target is the actions of our monetary policy. We also do think that we will not experience the same energy inflation every year. But let me also say, we do think there will be a second round of inflation. As we have already discussed, many sectors need to raise their prices because their costs have gone up. Many workers also have so far suffered a big reduction in their living standards, but we expect them to receive bigger pay increases next year and also in 2024 and 2025. These bigger pay increases will support expenditure and will also raise prices. That is why it will take some time to return to our 2% target. So the second round effects will drive inflation next year and in 2024.
After the measures taken, and considering the lag in the effect of monetary policy on the economy, is a more cautious approach to the next rate hikes appropriate? And should the brighter inflation outlook take some pressure off the need for further aggressive policy tightening?
The interest rate decisions we’ve taken since July have been cautious moves. Having a rate of -0.5% was no longer appropriate when inflation risks had gone up. So normalising monetary policy has been the prudent approach, and we have said that we still have more to do. But it is also true that we need to recognise that the interest rate decisions we have already made will help to reduce the inflation rate next year and the year after that. We do expect that more rate increases will be necessary, but a lot has been done already, so we will have to ensure we have a good understanding of the inflation outlook, and the risk factors when setting the interest rate on a meeting-by-meeting basis.
A few days ago, you said you didn’t see many arguments in favour of a 75 basis point increase in rates. Has your view changed, or has it now become stronger after the latest economic data?
Let me disagree with this description. What I said last week, and I will also say to you now, is that when we had very low interest rates, a move of 75 basis points was reasonably straightforward. So that made sense in September and in October. We will see in December what the correct decision will be. But the starting point is different now. We’ve already hiked rates by 200 basis points. We will still be guided by the inflation outlook. But we cannot decide on the appropriate size of the increase in any one meeting without considering the starting point. And the starting point is now a lot higher than where we were in previous meetings.
Does this mean that you are now suggesting smaller rate increments?
The higher starting point is one dimension of the debate, but of course in terms of the wider debate we will have to look at the overall outlook. The point I am making is that when we take future interest rate decisions, including in December, we should take into account the scale of what we have already done. So the basis for the decision will be different.
A lot of firms and households see the increase in rates as another burden on top of recession and inflation. Why isn’t recession enough to lower price pressures? How will the ECB ensure that there won’t be an unnecessary tightening for firms and households?
Our current thinking is that if there is a recession it will be relatively mild and relatively short-lived. If it is a recession of maybe six months and a mild one, then the reduction in aggregate demand in that case would be smaller. Compared to a more severe recession, a milder and shorter recession is good news for Europe but it does mean that its anti-inflation impact will be relatively limited.
I appreciate that the burden of the interest rate increases will not be uniform. For example, the households who have a variable rate mortgage will be more exposed than those who have a long-term fixed rate mortgage. And firms with a lot of debt will be more affected; and the implications are different for start-ups than they are for mature firms.
Which indicators will the ECB look at to determine the terminal rate?
We will always take a comprehensive approach. As I have said in my blog last week and other speeches, there are no shortcuts. There is no kind of special indicator that can uniquely tell us what the terminal rate will be.
But can you specify the main elements considered?
It boils down to all the factors that influence the inflation outlook. So, first and foremost, the inflation forecast. Second, the risks around that forecast. Third, there are the other indicators of the inflation dynamics. But, of course, we also take into account what is going on in the rest of the world.
In what way?
For example, if we think that the economy in the rest of the world is slowing down, or that global central banks will reduce demand through their own monetary policies, then the rate that we need to deliver will be affected. So our assessment takes into account the inflation outlook for the euro area, the global inflation outlook and the global central bank outlook as well. But in the end, we will look at a band of rates, not a single terminal rate. And to navigate that zone, the meeting-by-meeting approach will allow us to assess our immediate interest rate decision in the context of the zone of possible terminal rates.
Is this band of rates now higher than at the last Governing Council meeting?
I’m going to wait until all the data arrive, and the outlook is developed by the whole Eurosystem. We need to wait for the new Eurosystem staff projections. Once we have a good understanding of the inflation outlook, we will examine the implications for the terminal rate.
On the TLTROs, were you surprised by the low repayments by banks in November and do you expect more in December?
It’s important not to focus on the November number, but on how much banks may repay between November, December and January. Every bank is in a different situation and has different end-of-year considerations regarding the role of TLTRO financing in relation to overall funding. In general terms we think that there will be a significant reduction in the TLTRO liabilities in the coming windows, which is in line with the policy change we made.
On the quantitative tightening (QT) instead, how will the ECB ensure a process without market volatility? In December will only the principles be defined, or something more, too, like a timetable or an actual start of the operation?
It makes sense to have a two-step process. The first step is to define the principles. The second is to finalise a calendar. But I think that by now there is a universal consensus that is not specific to the ECB, that QT should essentially be a background programme. We would make sure that it makes its contribution to monetary policy normalisation in a way that reinforces the primary instrument, which is setting rates. Our main focus will be setting the policy rate, and QT will be operating in the background, in a predictable, measured way.
Do you envisage a passive QT with a percentage of maturing bonds in the asset purchase programme (APP) not reinvested?
The exact way we will decide to run down the APP will be decided at the upcoming meetings. But it is fair to expect that we will follow a steady approach. Every central bank is different in terms of the maturity structure of its portfolio, but the APP will allow a steady approach to be appropriate.
How will the ECB ensure that the anti-spread shield – the TPI – is effective? If we see greater fragmentation owing to monetary tightening, will the ECB be ready to activate that instrument?
We are super clear: we have a very good understanding of what’s involved. We know central banks can be extremely effective in any type of market stabilisation intervention. So the ECB will be very effective in its response to any kind of unwarranted fragmentation or disruption of the transmission mechanism. So there should be no doubt that we can be very powerful and effective in using the TPI.
Could more expansionary fiscal policies by governments push the ECB to hike interest rates further?
The basic answer is yes. If the euro area runs up larger fiscal deficits, this will increase overall demand in the economy and that will, in turn, imply higher interest rates to make sure that inflation returns to 2%. That is why we have made it clear that in the immediate response to the energy crisis, governments do still need to do a lot to protect the most vulnerable and to offer support to firms that face particular challenges. But it helps if this is temporary and targeted rather than excessively boosting aggregate demand on a persistent basis.
What should governments do?
If the interventions are temporary, then there shouldn’t be a big impact on the deficits next year or the year after, which is what matters over the medium term. It is also important to be targeted: you can help the most vulnerable, but in a way that is less costly than programmes with a wider reach.
So, it is possible to support households and firms needing support with temporary and targeted measures. But, if deficits were to remain too high indefinitely, this would add to demand pressures.
What are the main changes linked to the energy crisis and what are the lasting effects in the medium to long term for the European economy?
A number of points can be made, assuming that there is only a limited reduction in energy prices so that these do not go back to pre-pandemic levels. Number one is that Europe will be collectively poorer because we are a big energy importer. Lower incomes due to these extra energy payments will reduce demand in the economy. Number two is that some firms that use a lot of energy will lose competitiveness on a global scale. So you would expect to see some industries relocate to regions where energy is cheaper. But then, there is also the third and more optimistic point.
What is that?
The response to the energy crisis is accelerating and will stimulate the green transition and investment in renewable energy. This will take some time, but then the energy supply will be more secure, because we will no longer be reliant on imports of fossil fuels. And it will be cheaper because renewable energy will have lower marginal costs. So, I do think there’s a very difficult period to come, but also a faster transition to a more sustainable economy.
What is your view on the European Commission’s proposals for the new Stability and Growth Pact?
There will be a debate on this topic, and let’s see the details of the decisions. But let me be very clear about this point: what is most important is that Europe agrees a fiscal framework as early as possible in 2023, because we really need it to help European governments make decisions for 2024 and later years. We need a fiscal anchor to make sure that governments are able to reconcile their response to the energy crisis with the commitment to sustainable debt in the medium term.
But for monetary policy, which is the bigger risk? Doing too much or too little?
It is important to recognise that the worst-case scenario is one where inflation remains too high for too long. History teaches us that it is very costly to get rid of entrenched inflation. We need to avoid that by making sure that inflation goes back to 2% in a timely manner. But, subject to that imperative, we also want to make sure that we’re efficient and that it is done in a way that does not lead to overshooting and to an excessive reduction in economic activity. So I don’t think it is a good idea to make a binary decision between too much or too little. There is a hierarchy: we need to get inflation back under control and towards the target. But we also need to recognise that once we are closer to target, the risk of overshooting may emerge.
Can you specify what you mean when you say that you want to get inflation back to 2% “in a timely manner”? In what way does the meaning of this expression differ from “in the medium term”?
This is a very important point. The ECB has always said that we have a medium-term approach, but without providing a precise definition. The medium term can be longer if the deviation of inflation is not too great, but should be shorter if we have a big inflation gap to fix. This is the case at the moment. So, we use the expression “in a timely manner” not to tie us to any particular year or period of time, but to essentially signal that we want to get inflation back to 2% at an appropriate speed and not to take too long. So, it’s not satisfactory to say that inflation will be at 2% many years from now. We have to make sure that inflation is back to 2% within a reasonable time horizon, and the Governing Council will decide exactly what that will be.
Some have criticised the ECB’s approach of focusing solely on inflation, sometimes even in the short term, thereby ignoring the effects on the economy and on financial stability. The mandate is for inflation, but could defending your credibility on prices lead the ECB to make decisions without a more comprehensive assessment of the economy?
We always consider all dimensions of the impact of our policies. We always make sure that we’re proportionate in our decisions. The primary focus is on inflation. What matters is the inflation outlook in the medium term, which also depends on the economy and is not only linked to current inflation. You can be confident that we will make sure we meet our price stability target, but without causing excessive side effects for the economy and financial stability.