Interview with Le Monde

Interview with Fabio Panetta, Member of the Executive Board of the ECB, conducted by Eric Albert

2 June 2023

The ECB’s objective is to keep inflation at 2%. It is currently at 6.1%. Should people be worried?

There is no doubt that 6.1% is too high, but people should not be worried. We will bring inflation back to 2%. In less than a year, we have raised interest rates decisively, from -0.5% to 3.25%, and inflation is falling, as confirmed by yesterday’s data.

As a result of our rate hikes, banks are increasing lending rates and reducing the loan supply. This is being passed on to the real economy: firms are taking this into account when they plan their future investments, as are households when they take out home loans. But monetary policy typically exerts its impact over extended periods. It takes several quarters before its effects are fully felt by the real economy and then transmitted to inflation.

But how long will it take before inflation returns to a reasonable level, like 3%, for example?

Our March projections suggest that inflation should hover around 3% early next year and approach 2% in 2025. However, this scenario does not account for any potential, unforeseen shocks.

Since the autumn of 2021, the ECB has been saying that inflation will soon return to 2%. Why should Europeans believe you now?

Investors understand that inflation has risen because of a series of adverse global shocks that are beyond the control of monetary policy. They know that we will intervene until we see inflation heading convincingly towards our 2% target and they expect it to return to that level. So far we haven't succeeded, but not because of the reasons suggested by commentators in 2021 who predicted a sharp rise in inflation. Nobody had foreseen the severity of the supply chain bottlenecks, the war in Ukraine or Russia’s manipulation of energy supplies. Without these unpredictable events, the economic landscape would be quite different, with significantly lower inflation.

Does inflation only reflect the war and the pandemic? In 2020-21, euro area governments had built up a very high deficit. This massive stimulus was only possible because the ECB made huge debt purchases. In hindsight, was this a mistake? Did you loosen monetary policy too much?

We are too quick to forget that the combined intervention of the ECB and governments following the pandemic saved the euro area from an economic depression. In 2020 the euro area economy contracted by 6%. Imagine the potential fallout had we not acted decisively: the risk of falling into a prolonged recession and of deflation, which could have led to an economic depression, was real. The subsequent economic recovery has contained the deficit and debt as a percentage of GDP. Inflation was largely caused by bottlenecks and the war, not monetary policy.

We are now addressing the inflationary consequences of these shocks, and our actions should be measured against our success in curbing inflation. In this respect, as proven in the past, we are fully determined to reach our 2% target.

Is inflation still fuelled by supply shocks? Inflation in the services sector is high – it was 5.0% in May – and core inflation (stripping out energy and food prices) is at 5.3%, which is more likely to be demand-driven.

I don’t think strong domestic demand is our main problem. In the last quarter of 2022 the euro area recorded a fall in consumption and investment. It is mainly foreign demand that is underpinning growth. The main threat to price stability derives from the strength of the labour market and firms’ profit strategies, although so far there are no clear indications of a self-sustained wage-price spiral.

Core inflation does not accurately represent the typical consumption basket, especially for low-income consumers. More importantly, as I have said in the past, it is not a good leading indicator for future headline inflation. Core inflation usually lags behind headline inflation. And just as it has lagged behind energy inflation on the way up, it is now proving to be persistent even after energy inflation has gone down. But we can expect it to come down eventually too. In this respect, yesterday’s figures are encouraging.

Growth in the euro area was just 0.1% in the first quarter. Isn’t there a risk that rising interest rates will stifle what little growth there is?

Our rate increases aim to prevent inflation from taking root for too long. The good news is that the European economy hasn’t plunged into the deep recession that some had predicted, thanks to more rapid-than-expected drops in energy prices and to fiscal support. But our monetary tightening will be felt in the coming months. We cannot rule out the possibility that domestic demand will continue to be weak and that this will translate into a prolonged weakness in economic activity or even a technical recession.

So, how high should you continue to raise interest rates?

Given the extraordinary level of economic uncertainty, estimating the terminal rate is challenging. Our decisions are currently guided by developments in economic data, which we assess on a meeting-by-meeting basis. I don’t think this is the time to be too hasty in raising rates, given the considerable ground we have already covered. My intuition suggests that we have not reached the end of our rate-hike cycle, though we’re not far away from it. I think the policy debate will soon shift away from “how high?” to “how long?”. There is substantial scope for fighting inflation by keeping rates high for as long as necessary. We should be resolute yet judicious, with the aim of lowering inflation without unnecessarily harming economic activity.

Has Europe suffered a permanent loss of competitiveness as a result of the war? It no longer has access to Russian gas. At the same time the United States is paying very high subsidies through the Inflation Reduction Act, and the Chinese are doing the same.

The European growth model of the last 20-30 years is running out of steam. This model, based on cheap energy and offshoring – particularly to China – focused largely on exports, compressing domestic demand, especially in large economies. But export-led growth is not a natural fit for a large economy such as the euro area and it exposes us to excessive fragility, especially during phases of geopolitical tension, like the current one. The euro area is in a position to determine its own economic destiny.

We need to revisit our growth model, adapting it to the new geopolitical landscape. The European summit in Versailles in March 2022 marked a significant milestone, as Europe recognised the need to invest in common public goods in areas that are crucial for fostering growth and improving competitiveness, such as the energy sector, the green transition and new technologies.

Perhaps, but the governments that are currently investing a lot of money are the United States and China. Meanwhile, Europe is talking the talk but not walking the walk.

On a standalone basis, no one European country can resist the allure of the US market and the money available through the Inflation Reduction Act. That’s why we must adopt a pan-European strategy, deploying common fiscal instruments, like we did with the Next Generation EU package in response to the pandemic. Our fiscal policies must remain prudent, but we must learn the lessons of the financial crisis. Then, we thought we could remedy the problems of high indebtedness by suppressing demand, when what was actually missing was growth. As a result, public investment declined, growth collapsed and debt ratios surged. We should never repeat those mistakes.