Interview with Handelsblatt
Interview with Fabio Panetta, Member of the Executive Board of the ECB, conducted by Andreas Kröner, Jan Mallien and Frank Wiebe
24 January 2023
The guidance the ECB gave in December has been tested by markets recently. There seems to be some confusion about your next moves. Have markets got ahead of themselves?
Our December projections foresaw inflation above our 2% target until mid-2025. Given that inflation had already been high for some time, this triggered a further monetary policy adjustment. It was reasonable to increase rates in December and signal a similar step in February. But beyond February any unconditional guidance – that is, guidance unrelated to the economic outlook – would depart from our data-driven approach. Our December decisions were based on the projections available at that time. In March we will have new ones and should reassess the situation.
But don’t you think that the ECB should provide markets with guidance on the next moves?
Yes, but not unconditional guidance. We strive to be predictable, but the current situation does not require us to commit to a specific rate path for too long or without reference to the data. Commitments on future monetary policy over a long horizon were justified in the past (we called it “forward guidance”) when rates were at their lower bound, so that we could only act upon expectations of future rates by signaling that we would keep policy rates low for long. But we are not in that situation anymore. Today we are fighting too-high inflation, and to do so we can bring rates as high as we deem appropriate to reach our target.
Also, there is too much uncertainty in the economy to unconditionally pre-commit to a specific policy course. There is uncertainty on the evolution of the war, on energy and food commodity prices and their pass-through to retail prices, on the reopening of the economy and its effects on supply chains, on the global economy (think of China and the United States), on the domestic economy (will we have a recession?), and on the impact of these developments on productive capacity.
So what should be your strategy in the current context?
We should provide clarity on, and be guided by, our reaction function, which is rooted in our price stability mandate and consists of two main elements. The first is the economic and inflation outlook: we will react to medium-term inflation remaining above our target. The second is the risks surrounding this outlook, today mainly related to the possible emergence of second-round effects: we want to prevent a de-anchoring of inflation expectations or the start of a wage-price spiral.
What will then determine your next moves?
It will be the economy, of course, and how its evolution will affect the two elements of our reaction function. Depending on this assessment, we may decide that more or less tightening is needed compared to what we envisaged in December. We should thus not be surprised that investors adjust their expectations of future rates as new data emerge. But we need to make our own reading of these data clear to them.
Your projections foresee a rapid inflation fall in 2023. But for 2024 and 2025 you have revised your inflation projections up, above your 2% target.
You are right. The December 2022 Eurosystem staff projections foresee that inflation will drop sharply, from 8.4% in 2022 to 3.6% by the end of 2023, mainly reflecting lower energy prices. But it will then stay at around 3.4% in 2024 and will reach 2% only in the third quarter of 2025.
So energy prices are falling but inflation will still remain above your target. What is behind this evolution?
In 2024 and 2025 projected inflation remains above target for two main reasons. The first one is that the projections assume that wages will pick up in the coming months.
So far, the combination of fast-rising prices and moderate wage growth has meant that workers have suffered a large loss in real income, shouldering most of the terms of trade “tax” that Putin has imposed on Europe. As a result, their share in income distribution has decreased. Over time we may see a rebalancing. But this would not necessarily signal the onset of a wage-price spiral. It may instead reflect a different allocation of the Putin “tax” between wages and profits, allowing a one-off catch-up in wages. This may be absorbed by firm mark-ups after their recent increase or through a fall in other input costs such as energy.
And what is the second reason?
The second reason is related to our staff’s judgement on the fiscal measures that aim to smoothen the effects of the energy shock. A good part of the upward revision of the December inflation projections for 2024 and 2025 reflects the fact that the price-based measures taken and announced by governments are expected to curb energy prices and inflation in 2023, when they are introduced. But they are expected to have the opposite effect when they are withdrawn, likely in 2024, pushing inflation up with carry-over effects in 2025, delaying the return to our target. The effect on inflation is in good part due to the fact that most of these fiscal measures are not limited to vulnerable population groups, but rather provide generalised support that is, on balance, inflationary.
My concern is that this effect of fiscal measures – which is included in our baseline projection – is largely the result of judgement and is surrounded by very high uncertainty. Discretionary fiscal policy is hard to predict. For example, spending on energy support will likely be lower if energy prices continue to decline – indeed, last week the German government made an announcement of this sort, saying that falling prices could lower its spending on energy price brakes.
And importantly, this interaction between monetary and fiscal policies is highly inefficient. The risk is that fiscal measures that were introduced to shelter consumers from high energy bills and protect their purchasing power could, paradoxically, trigger a contractionary monetary policy reaction that would hit the real economy, reducing households’ incomes and increasing the interest bill for governments. It would be like giving with one hand and taking away with the other.
How can this be avoided?
Governments may decide to revise their measures, for instance by moving towards income-based, targeted support to vulnerable citizens, to avoid those undesirable oscillations of inflation. Some Member States are considering this possibility. This could make an important difference for monetary policy, reducing the cost of bringing inflation down. And it would benefit public finances, by lowering governments’ cost of borrowing.
What are the new economic developments since December?
We had some good news on the inflation front, as it is likely that the supply shocks that have hit the economy in recent months are starting to reverse. We can afford to be “anxiously optimistic”, but we should be prudent and remain vigilant.
Energy inflation might abate further if the recent fall in wholesale electricity and gas prices – which have so far declined by more than we had assumed in December – is sustained and reflected in retail prices, which typically takes a while. Lower energy prices are unambiguously good news: good for the economy and good for inflation. They bring down realised inflation and contain the loss in real income, reducing the risks of second-round effects and supporting economic sentiment.
How long will it take before citizens can see tangible signs of improvement?
It will take time, and we may see ups and downs, but some positive signs on the inflation front are emerging. For example, the seasonally adjusted three-month inflation rates (which capture the latest dynamics of inflation) have decreased in recent months as regards not only headline but also core inflation. Other recent developments could support this trend: the euro has appreciated by 6% versus the dollar since our December projections, while the adjustment in our policy stance is contributing to tightened financing conditions. Lending to firms and households is slowing. All these elements will play an important role in the March projections.
So, can we say that monetary policy is prevailing over inflation?
Not yet. As I said, it will take time before the developments I just mentioned are fully reflected in retail prices. Moreover, they could stop or reverse, while the recent improved economic data will support core price pressures. And we remain far away from our target. We need to continue closely monitoring the economic and inflation outlook.
In sum, what are the implications for monetary policy?
We must live with uncertainty and be prepared to adjust our monetary policy stance. Inflation is still too high, but recent developments suggest that we can fend off the risks of second-round effects and bring down inflation by continuing to adjust our policy rates in a well-calibrated, non-mechanical way.
Monetary policy operates with lags, which means that the effects of the fastest tightening in the ECB’s history have not even started to be fully felt. We need to take those lags into account to avoid having to reverse course, which would be costly given the lower flexibility of the euro area economy compared to economies like the US. We need to keep our policy dependent on incoming information, providing markets with the necessary conditional guidance on the basis of our reaction function. We should do all that is necessary to bring inflation down to 2% without undue delay, at the minimum cost to the economy.
On the basis of your analysis, what should be the next ECB policy move? A rate hike of 25 or 50 basis points?
I am happy to discuss my reading of the economy and my views of the broad implications for our monetary policy. But a detailed, public discussion of actual policy measures – a discussion of basis points – would be inappropriate. That discussion should take place within the Governing Council of the ECB.
In your home country Italy, the ECB's December decisions have been criticised. What do you think of that?
It is important to emphasise that countries with higher debt – both those with high public debt, and those with high private debt – benefit the most from a credible fight against inflation. After all, it is precisely in these countries that low inflation leads to low compensation for inflation risk (the inflation risk premium) and thus also low yields on bonds. In the past two decades, euro area sovereigns generally enjoyed low funding costs, despite rising debt-to-GDP ratios in a number of countries, largely thanks to the ECB’s ability to preserve price stability.
So you do not see monetary policy as a source of risk for Italy?
Not really. Italy’s fiscal policy has remained prudent. Rising interest rates had already been factored into the budget plan; and current market conditions are even slightly more favourable than those foreseen in the budget. Moreover, the average maturity of Italian public debt is equal to 7.8 years. This means that an unexpected increase in market yields would have a very limited impact on Italy’s interest bill in 2023. And let’s not forget that growth is the main driver of debt reduction. Italy grew by more than expected in 2022, and above the euro area average. Looking ahead, it can still invest significant resources – about 9% of GDP – thanks to the Next Generation EU. This makes it difficult to imagine a country risk if the path is followed.
Let's move on to a different topic: the digital euro. To what extent can the ECB make decisions about this on its own?
This is a highly political project and the ECB will not move on its own. We are coordinating closely with co-legislators. The European Commission will put forward a legislative proposal in spring this year, which will be discussed by the Member States and the European Parliament.
What points have been clarified so far?
One thing is clear: we are preparing ourselves to make public money available in digital form while still offering it in physical form – we will continue to offer cash. As with cash, we want to ensure that everybody in the euro area has easy access to the digital euro. To this end, we will work with supervised intermediaries such as banks, as they are best placed to interact with end users. We are designing the digital euro with the highest possible level of privacy. The ECB will have no access to personal data.
In many countries, it is already common to pay digitally. Who needs a digital euro anyway?
In the euro area, it is currently not guaranteed that everyone can pay everywhere with a single means of payment. Cash cannot be used for online payments, and existing digital solutions cannot be used in all countries. The digital euro is a natural step forward for our single currency: it would overcome the fragmentation of payments within the monetary union, through a means of payment that is ultimately governed by Europeans.
It is also important that citizens who prefer to pay digitally should have the option to pay with central bank money. This is a matter of sovereignty. And the digital euro would provide a monetary anchor that allows everyone to be sure that one euro is always one euro, as any form of money, such as bank deposits, can always be converted to riskless central bank money, be it cash or a digital euro.
But the digital euro also entails risks: if during a financial crisis people quickly exchange their bank deposits for digital euros, the crisis will be even greater.
We will make sure that a digital euro does not create financial stability risks. It will be designed to enable an upper limit to be set for digital euro holdings, although no decision has been taken yet on the precise amount. We want the digital euro to be a means of payment, not a form of investment.
And what happens if someone receives digital euros but their limit is already exhausted?
Then the amount in excess would be automatically converted into a deposit held in a bank account chosen by the recipient.
Technically, will the digital euro be based on a blockchain, similar to bitcoin?
We have not decided, because technology should follow functionality. Also, it is unclear whether a decentralised solution like the blockchain could cope with the volumes that could be generated. We are currently conducting market research to gather views on possible technological solutions. In any case, our infrastructure will bear no relation to bitcoin, which is not money and relies on a technology that is highly inefficient and devours huge amounts of energy.
Which questions in the concept are still open?
For example, whether it can be used outside the euro area and if so to what extent. There are calls to make the digital euro usable worldwide. But even if we limit holdings to, say, €3,000 per person, that could generate financial tensions in the domestic financial systems of some countries outside the euro area.
Who should bear the costs for the digital euro, the citizens?
No, our working assumption is that its use will be free of charge for consumers, similar to banknotes. There could be cost compensation flows similar to those applying to card payments between the bank of the merchant and the bank of the payer, and there could be a merchant fee. We are discussing these questions with the Commission.
Your term of office runs until the end of 2027. Do you think the digital euro will be realised in that time?
For all the enthusiasm I have for the project, no decision has been made yet on whether the digital euro will be issued. In any case, the preparations will still take a few years.
But you already believe that the project promises success?
I want the digital euro to be successful, not dominant. It should complement rather than replace other payment methods. We want to offer a public good to citizens, which will coexist with other means of payment including cash. Citizens will then decide if they want to use it. We thus need to make it attractive to them by guaranteeing convenience, privacy, efficiency and safety.