Interview with Il Sole 24 Ore
Interview with Luis de Guindos, Vice-President of the ECB, conducted by Isabella Bufacchi
14 May 2023
With seven hikes in one year, the ECB has raised interest rates at a very rapid pace, by a total of 375 basis points, to bring inflation back to its 2% medium-term target. This unprecedented monetary policy tightening has come after many years of low rates, and at the same time as Russia’s invasion of Ukraine has brought war to Europe, as well as the energy crisis and the risk of recession. Beyond just price stability, does the ECB take into consideration the impact of this monetary policy tightening on banks and financial stability?
Our mandate is price stability and tightened monetary policy is a response to the very high inflation we face. This has fallen from the 10.8% we saw in October last year, but it remains high. Still, despite the very strong tightening cycle, we have not seen any financial stability problems. Yields on government bonds have increased, but spreads have remained fairly stable. This rise in interest rates has not resulted in greater fragmentation. Moreover, European banks’ balance sheets are improving, with higher-than-expected profits in the first quarter of this year. There is some tension in the European non-bank financial intermediary sector, which is highly leveraged and more exposed to liquidity risk, but nothing comparable to the banking crisis in the United States.
And do you consider the effects on households and businesses, and on the economy?
We do. Higher interest rates have started to affect businesses, but there has been neither a wave of defaults, nor of fallen angels (bonds once rated as investment grade now downgraded to speculative grade). Regarding households, a strong labour market continues to offer support for coping with tighter financing conditions. So far so good, I would say. But, of course, we continue to monitor the situation and we take a wide range of indicators into account.
There were fears that the ECB’s highly restrictive monetary policy would only be able to tackle inflation at the cost of a recession in the euro area, but that does not appear to be the case…
Indeed, our forecasts in December pointed to a technical recession, but we revised them in March. Growth was flat in the fourth quarter of 2022, and slightly better in the first quarter of 2023. The euro area managed to avoid a technical recession. Nevertheless, contractionary monetary policy serves to tighten financing conditions and we have started to see this being felt on the market for bank loans. Banks have started to tighten lending conditions, which shows that monetary policy transmission is working. And we will see what impact this will have on the real economy.
The Governing Council’s latest decision was to raise interest rates by 25 basis points, a smaller increase than the previous 50 and 75 basis-point rate hikes. However, the language used in the monetary policy decisions and by President Christine Lagarde at the press conference was more hawkish than dovish: “We have more ground to cover”, “we are not pausing”…
A quarter of a percentage point is “the normal” monetary policy rate hike. Hikes of 50 and 75 basis point were extraordinary steps in response to extremely high inflation. We have had to raise rates by 375 basis points: it was an important stage in our journey and inflation is in fact coming down. But we have now entered the home stretch of our monetary policy tightening path. And that’s why we are returning to normality, to 25 basis-point steps.
Were you in favour of a 25 basis-point hike, or would you have preferred 50?
Raising rates by 25 basis points was the right decision. I was in favour, even during our preliminary discussions on the Executive Board. And then, the overwhelming majority of the Governing Council supported the proposal. You could even say that there was virtually unanimous support for a quarter of a point.
And what’s next?
Looking ahead, it will depend on the data. We will decide on a meeting-by-meeting basis. And based on the evidence of how the tightening of financing conditions has worked. And on the path of inflation, headline and core.
Which of the two matters more: headline or core inflation?
Both will ease in the coming months. Energy prices will be key in determining headline inflation. We will need to consider the base effect as well as the impact of government support measures coming to an end. But core inflation will also be telling. It is a useful indicator for predicting inflation over the medium term. In this regard, I am concerned about service prices, which account for a large share of core inflation. Demand for services in Europe, for example in Italy and Spain, is very strong and highly sensitive to wage and labour market developments. We need to closely observe the impact of wages and services on core inflation.
At its last meeting, the Governing Council also decided to discontinue reinvestments of maturing securities in the asset purchase programme (APP) portfolio as of July 2023. Meanwhile the pandemic emergency purchase programme (PEPP) remains untouched, with no sales of securities before maturity: how meaningful is quantitative tightening (QT) as a restrictive monetary policy tool when applied to reinvestments under the APP only?
Interest rates are our primary monetary policy tool. Reducing and then stopping reinvestments under the APP, the so-termed QT, is fully aligned with our monetary policy stance. It works in parallel with raising interest rates and reinforces the tightening. We think it has led to an increase of 60-70 basis points in ten-year government bond yields. But the main tightening comes from the rate increase of 375 basis points, as that is our primary monetary policy tool. We will publish more data on the impact of our tightening in the coming days, but, still, calculations should always be taken with caution. Overall, effective communication of QT and the Transmission Protection Instrument have helped to avoid market turmoil with the end of reinvestments under the APP.
Another important tool is also under the spotlight, namely loans under the targeted longer-term refinancing operations (TLTROs). In coming months, the banks will repay €477 billion: can you confirm whether a kind of “bridge loan” formula is envisaged to mitigate the impact of this bumper repayment?
The TLTROs have served as an extraordinary tool in extraordinary situations, for example the pandemic, which is now over. Banks have planned to make repayments based on the roadmap. I expect that, for the June tranche, banks – even those that have made most use of the TLTROs – will not have any trouble rebuilding this liquidity. Apart from the alternatives of the main refinancing operations and longer-term refinancing operations, in extraordinary cases, we may revert to using TLTROs themselves as a valid alternative. They remain part of our toolbox.
Banks have had worse things to worry about than TLTROs: first the pandemic, followed by the war in Ukraine, the energy crisis and inflation. They have overcome many crises up to now.
Euro area banks are resilient in terms of capital and liquidity. And now, thanks to the higher margins from the rise in interest rates, profits are increasing as well. But we mustn’t drop our guard. We need to be very cautious: the combination of a slowing economy and the interest rate hikes will bring a rise in the cost of funding for banks and possibly an increase in non-performing loans (NPLs). At the moment, the improvement in margins more than compensates for the potential losses from the growth in NPLs. But we need to keep a close eye on developments.
And what about Italy’s banks?
Italian banks are in a very different situation to that of 10-12 years ago. Their resilience is not in doubt: they have more capital, are more liquid and have cleaned up their balance sheets, with NPLs falling to an unprecedented level of slightly below 2.5% of total assets. But just as for all European banks, everything will depend on how the economy performs. The resilience of businesses and households will be key. We do not expect a wave of NPLs, but now is not the time for complacency.
Are there lessons to be learned from the banking crisis in the United States?
The crisis that hit US regional banks served as a wake-up call: we saw how market sentiment can change abruptly. The situation in Europe is different. It is not so exposed to the systemic risks faced by the US regional banks and has, for example, a much larger retail deposit base. But the fact remains that digitalisation and social media can play a role in quickly driving bank runs. That’s why I am convinced that the EDIS (European deposit insurance scheme) is a crucial step. It is imperative that we complete banking union by equipping ourselves with the EDIS. Having an incomplete banking union could end up being one of the biggest chinks in our armour. I would even say that lacking the EDIS is the main vulnerability for the European banking system. Not introducing it would be a serious mistake.
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