Interview with Reuters
Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted on Friday, 24 February 2023 by Balázs Korányi and Frank Siebelt
28 February 2023
What is your assessment of economic developments since your last meeting or since the December projections?
Since the December meeting – that is the relevant timeline for us – we’ve experienced several favourable supply shocks.
There’s been a strong decline in energy prices, particularly for gas. This is a partial reversal of the stagflationary shock we had last year. Such a supply shock is better for GDP and should also lower the inflation rate. So it’s a good news story.
Then we’ve seen confirmation that the bottlenecks continue to ease. That’s probably most visible in the rebound in car industry production in recent months. That’s significant for the European economy. The easing of bottlenecks is also good news for GDP and for pricing pressures.
On top of that, we have the reopening of China, which I interpret as a favourable supply shock, as Chinese firms are now back looking to compete on the global market. We also have fewer concerns about pandemic restrictions in China creating new bottlenecks. But of course there’s also an impact on the demand side, because China is set to grow quickly this year. This reopening will boost global demand for commodities and foreign demand for the euro area.
Another favourable demand shock is the labour market. We continue to have good news about the labour markets. There are ongoing increases in employment and probably a reassessment in the direction that the risk of losing your job is going down.
Not disconnected from all of this, we’ve had confirmation that the fiscal support governments gave in the last months of last year helped many households preserve their income and consumption.
We’ve also had confirmation that our monetary policy is working. We’ve seen significant increases in the yield curve, significant increases in bank lending rates, declines in house prices in a number of countries and we see a tightening of credit conditions that we expect will lower credit volumes. This is of course just one stage of how monetary policy works. But I think there’s significant evidence that monetary policy is kicking in.
Some of these factors are essentially near-term in nature. The improvement in the energy price situation will in the near term lower inflation and boost GDP. But if you look further, to 2024, to 2025, the tightening of monetary policy has been significantly more than what was baked into the December forecast and that has to be factored into the new forecasts.
Some of these factors are inflationary, particularly what you said about growth and the labour market. Once aggregated, do you expect your 2025 inflation projection to come down?
I will not pre-empt the aggregation work of the staff on the new projections. But the supply shocks, on net, lower inflationary pressures. With regard to the war against Ukraine, we should not interpret the situation simply as an energy crisis. The war will be a first-order, fundamental issue for Europe in the coming years. We saw last year an immediate and big drop in consumer and investor confidence. This was not just because people were facing higher energy prices. The war raised questions about lots of issues, about the future of trade, geopolitics and so on.
But the worst-case scenarios we faced around last September and October, where people feared outright rationing of energy, have not materialised.
Consumer and investor confidence is an important demand-side issue, and we had a big slowdown last year. Growth ended up just marginally above zero in the fourth quarter and this outcome is a lot worse than we had in our projections at the start of 2022.
There was a lot of uncertainty in the autumn about what would happen when the crude oil sanction kicks in or what would happen when the refined oil sanctions kick in. But there’s been a lot of substitution by European firms, governments and households. There’s been a lot of resilience, and I think that’s very reassuring.
There’s also going to be significant volumes of new information coming in after March. In April, we’ll have the stability programme updates from governments. We emphasised in December the crucial role for fiscal policy with regard to how much overall demand expansion they’re providing, specifically on energy prices and the design of different subsidies.
Clearly, with the turnaround in the wholesale markets, many governments do have to think again and make sure that their measures are tailored and targeting those who are most vulnerable. With the stability programme updates, we’ll see more about how governments plan to respond in 2024. For our medium-term perspective, these fiscal policies will be very important.
In April, we’ll have another round of the ECB’s bank lending survey. The last one showed that quite a lot of tightening is in the pipeline. Banks are also reassessing their lending. Maybe the brighter GDP outlook causes them to reassess their attitude to credit. But then there’s the issue of the ongoing increase in funding costs, the declines in housing prices and so on.
The first-quarter GDP will also be an important data point for us.
It’s interesting to think about the March forecast but we are entering a fairly long phase of very rich data flows, which will help us reach firmer conclusions on many of these points.
Do you see any reason not to go through with the 50 basis point rate increase in March? Could you also run us through your criteria for ending rate hikes?
Our assessment of December remains solid, that we needed a sequence of 50 basis point hikes to bring us inside a zone where we would need to think harder about whether rates are sufficiently restrictive to deliver the return of inflation to 2%. The data flow since then suggests that the assessment is solid, that we need another 50 basis points in March.
Then there are three criteria for what happens after that.
One element is our inflation projections, and here I mean the whole path, not just the end point. The second is progress in relation to underlying inflation, and the third is an assessment on how powerfully and how quickly monetary tightening is working.
With regard to the forecast, it’s about the cumulative deviation from the target. Any deviation from the target is costly in terms of delivering on our mandate. So the larger and the longer the material deviation from 2% is, that is significant, in addition to the forecasted speed of convergence to our target.
On underlying inflation, we also need to look at actual outcomes, because forecasting techniques are limited, which is even more true now, given the volatility and the shocks we’ve seen. So we’re all signed up to the criterion that sufficient progress in underlying inflation is important. The issue is how to interpret that criterion.
Typically, step one in assessing inflation is to take out energy and food, because these are usually more volatile. That said, we cannot forget about energy and food entirely because these are fundamental to the cost of living. The higher headline inflation is, the more pressure there will be on the cost of living, on wage inflation and other elements which go into core inflation, since underlying inflation is heavily influenced by headline inflation.
Food inflation is very significant. Food has twice the weight of energy in the overall index.
As for core inflation, it’s difficult to overstate the importance of recognising that the drivers of goods inflation and services inflation are quite different. Looking at core inflation as an aggregate is not super helpful and I think we need to look at the dynamics of goods inflation and services inflation in a more granular way.
For energy, food and goods, there’s a lot of forward-looking indicators saying that inflation pressures in all of those categories should come down quite a bit. The reason I say that is because there’s a wholesale level of pricing and there’s an intermediate-level pricing, and price pressures at these earlier stages are turning around.
Actual goods retail prices are still very strong, but the intermediate stage has been a good predictor of price pressures. The fact that these are turning around, including through the easing of bottlenecks and global factors, suggest that there will be significant reductions in inflation rates for energy, food and goods.
The services sector is what we need to watch in particular. There are two big questions about services inflation. One is the interconnection with wage inflation, because a lot of service sectors are quite labour-intensive. The second issue, which cuts across a lot of service sectors, including contact-intensive and energy-intensive sectors, is that these had a lot of unusual pricing last year.
Transportation, hotels and restaurants suffered a big cost shock from energy price increases. The contact-intensive sectors also had a reopening effect last year. There was a very strong demand for tourism with big price increases for transportation, travel, hotels and restaurants. That created a mismatch in sectors, which in the short term had little scope to improve their supply capacity.
One year later, we can expect airlines to better plan capacity and hotels to plan more recruitment for the summer.
So the supply-side component of services inflation should ease. But we very much have to maintain our focus on wages, which are now rising across Europe. So the sectors I mentioned may be simultaneously facing a better supply capacity, normalisation of demand and rising labour costs. The net effect on pricing is going to be a very data-dependent issue.
Corporate margins rose very sharply last year. How can a central bank deal with inflation fuelled more by profitability than wages?
We fully recognise this and this is an important point. The economics of profitability suggest we might see more of a profit squeeze coming up. The tightening of monetary policy works by dampening demand. The fiscal stance is also going to be a significant factor for overall demand in the euro area. European firms in many sectors are selling globally, and that’s where the re-entry of competition from Chinese firms could be relevant. In euro area manufacturing, pricing decisions have been heavily influenced by the pricing decisions of their competitors around the world. And goods inflation in the United States is off quite a bit. European firms know that if they raise prices too much, they will suffer a loss in market share.
Last year there was a perfect storm of pricing pressures and pricing opportunities. I expect that to be a lot less this year.
On the cost side, there are going to be higher labour costs. But firms in many sectors raised prices by a lot more last year than their increase in costs. So there is plausibly room for unit profits to fall in a number of sectors. There is also room for core inflation to fall if unit profits normalise in those sectors.
For us, it’s not just about the latest number – we need to separate the persistent factors from the factors which may fade. There’s a lot of forward-looking indicators which suggest that inflation is going to fall. But right now, there is still momentum from last year.
There are open questions on services. Is it the case that these extraordinary unit profits have room to narrow because of an extra year of adjustment to the reopening, the dampening of demand and the scale of momentum in wage inflation?
Interest rates are most effective when they are set in a durable fashion. Wherever interest rates settle down, we basically need to balance the incoming hard data, but also our forecasts, our future data.
Let’s say inflation starts to fall in line with the forecast. If we settle into our durable plateau of interest rates, it will not be the case that in the first month of a significant fall in core inflation we would need to immediately start revising our plan.
Staying the course has two components. One is to bring rates to the levels that are needed, with a durable approach towards that level. We also need to make sure we do not start the phase of bringing rates back down to their long-run steady state until we have a high degree of confidence that the target is secure.
Core inflation may fall below the headline rate this year. What is the policy implication of this?
We should have a strong focus on underlying inflation dynamics, which is not the same concept as core inflation. We should also recognise that underlying and headline inflation are not independent. If there is a big decline in headline inflation, that will reduce pressures for wage increases, because the number one theme in wage bargaining right now is compensating workers for the high inflation that has already happened.
If headline inflation is coming down, that improvement, or less bad news about the cost of living, will lower pressure for high wage increases going into 2024. This is fundamental, and I don’t think there’s a contest between underlying inflation and headline inflation.
Where do rate hikes end, and is it clear to you, like many of your colleagues say, that more hikes are needed beyond March?
All those comments and market pricing are scenarios. If it is deemed that the inflation forecast hasn’t improved enough or we’re not seeing sufficient progress in underlying inflation, or we think the monetary transmission mechanism is working too slowly, then you can say with a set of conditional statements that a higher rate will be desirable.
But this is why we said in our last meeting that we intend to bring in another 50 basis point hike in March and then we will evaluate the post-March policy path.
The overall philosophy is that we will bring rates to a level that is sufficiently restrictive, which depends on where the inflation forecast is, where we are with underlying inflation and where we are with the monetary transmission mechanism.
So I don’t think it’s a good idea to focus on a dot plot.
Are we already in restrictive territory?
When raising interest rates, there isn’t an instant reaction from the whole economy. Let’s take 2023: some people in the past six or seven weeks may have seen their previous fixed rate mortgages expire and now face a higher rate. Some people may be thinking about renovating their home or buying a car. Those people are being hit right now by the change in the interest rate environment. Every month, every quarter, more and more people will be exposed to the new interest rate environment, and thus the impact of monetary policy accumulates. So far only a minority of firms and households have been fully exposed to the rate increases. This is why the second half of this year will be very important, because it will be a full year since we started hiking.
We expect to get our policy rate to 3% in March, and according to a wide range of ways of thinking about it, that’s a restrictive level.
There is a universal conviction that when inflation is stabilised at 2%, we are not going back to the pre-pandemic scenario of super low level of interest rates and quantitative easing. So there’s a permanent component in the shift of the monetary regime. In various surveys and data, investors predict that the policy rate will settle down in the neighbourhood of 2%. Once we’re back at target, then compared to our earlier policy rate of -0.5%, 250 basis points of our rate increases will essentially be permanent.
On this basis, according to this market assessment, anything above 2% is viewed as temporary and in that sense restrictive, because it’s not a permanent increase. It could be quite a long-lasting period, a fair number of quarters, but not forever.
Another area which may operate more quickly is asset pricing, including house prices and the evaluation of investment projects. It’s straightforward for residential real estate and commercial real estate. But it’s also significant for those sectors where the whole economic model has been to rely on losses now and profits in the distant future, with the discounted present value of future earnings lower as a result of higher interest rates.
If you believed in “low for long” and now see there’s a permanent increase in rates of 250 basis points on top of the cyclical increase, then ultimately monetary policy works more powerfully than normal.
Once rates plateau, how long should they stay there?
Our Survey of Monetary Analysts expects a significantly long plateau. I’m not commenting on whether that’s too short or too long. But I absolutely sign up to the monetary policy philosophy that wherever we get to, we should be slow to come down until we have very strong evidence – not just in the forecast but also in our ongoing assessment of underlying inflation – that we are returning inflation to target.
Whenever we do come to this point, I imagine that we will bracket the decision to hold rates with a clear commitment, which I would definitely share, that if it turns out more is needed, then we will do more. We should not be reluctant to revisit whatever level is needed.
The market is pricing a terminal rate by mid-summer and a rate cut at the start of next year. Is that a plausible period for a plateau?
There are several factors which can lead to a divergence between the market view and the central bank view of the future interest rate paths. There’s quite a wide range of estimates, with this high uncertainty that we have about what’s going on in terms of the impact of the energy crisis, the impact of the war, the impact of global tightening and the impact of our own tightening. So the market may collectively have a different view to us.
There’s high value in durability, so not responding to every twist and turn in data.
Both you and Isabel Schnabel have argued that transmission may have slowed down, and Ms Schnabel said this could call for more forceful monetary policy action. What’s your view on this?
This is a complex question. Just a few minutes ago we talked about factors that may have increased the power of monetary policy. The fact that we’re moving from super low rates and the fact there’s a significant permanent component in these moves increase the power of monetary policy. The fact that the economy has a lot of sectors which rely on intangible capital and distant future earnings increases the power of monetary policy.
Then we come to the speed of monetary policy. The fact that there are fewer floating rate mortgages now is a mitigator.
In a number of countries, the fact that households are now less indebted compared to 2008 is significant. The fact that the banking sector is well capitalised may slow down monetary policy but in a very welcome way, which is avoiding that tightening spills over into a full-blown credit crunch.
The fact that in 2008-2012 Europe had a lot of financial distress, which was definitely disinflationary, doesn’t mean we think that is how monetary policy should work. Monetary policy should work more smoothly. But I would agree that monetary policy is working less dramatically, in the sense that it’s smoother. And this is why we need to go back to what we just talked about: persistence. It could be the case for monetary policy to work in this way, through a persistent increase in rates.
The fact that we think monetary policy should work normally is something to view positively.
Fabio Panetta said that in restrictive territory, the ECB should move in smaller steps. Do you subscribe to this view?
When we started raising rates, I laid out my thinking on this issue, which boils down to two factors. One is distance to the terminal rate. In December we assessed the terminal rate de facto and we said there’s a significant gap, so we needed a number of significant moves.
The other factor is the risk assessment. This is where the progress in underlying inflation is going to matter, in addition to the forecast.
What’s a greater risk, doing too much or too little?
Let me differentiate between two risk assessments. One, the most important one, is what is the risk to our inflation target of 2%? I think the risk remains skewed to the upside. We look at scenarios, such as whether inflation expectations get de-anchored or a wage-price spiral gets embedded. You can definitely come up with plausible scenarios for inflation that doesn’t come back to 2% quickly enough. The scenarios where inflation falls below 2%, you can put some weight on them. But that’s fixable in the sense that if the inflation dynamic weakens more quickly, then we can adjust. But in the upside scenario, where inflation doesn’t come back quickly enough, then the longer it remains high, the more it becomes normalised, and then we have a significant problem.
But the reality is that there are a lot of possibilities on either side of the baseline. Look at the dramatic changes in gas prices since December.