Interview with Financial Times
Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Martin Arnold on 2 February 2024
7 February 2024
Now that inflation is fading, some say it was transitory after all. Can central banks claim much credit for bringing inflation down?
It's a myth that the inflation trajectory would have been the same in the absence of monetary policy action. Monetary policy was and remains essential to bring inflation down. If you look around, you see signs of monetary policy transmission everywhere. Just look at the tightening of financing conditions and the sharp deceleration of bank lending. Look at the decline of housing investments or at weak construction activity. And importantly, look at the broadly anchored inflation expectations in the wake of the largest inflation shock we have experienced in decades. Then ask yourself whether what we are seeing would have happened in the absence of monetary policy action. It's true, of course, that part of the decline in inflation reflects the reversal of supply-side shocks. But monetary policy has been instrumental in slowing the pass-through of higher costs to consumer prices and in containing second-round effects.
But doesn’t monetary policy act with this famous lag? Given that the ECB started tightening policy less than two years ago and only stopped in September, doesn’t that mean we are yet to see the full impact of your rate rises?
There's indeed a discussion about the lags of policy transmission. My view is that we are probably past the peak of transmission. This also connects to the question about the last mile of disinflation. Initially, we had the quick wins of disinflation, which is the reversal of the supply-side shocks. We've seen that quite impressively with inflation coming down from the peak of 10.6% in October 2022 to 2.9% only a year later. Since then, inflation has remained broadly stable. I would argue that we are now entering a critical phase where the calibration and transmission of monetary policy become especially important because it is all about containing the second-round effects.
You once drew a parallel between the final part of disinflation and long-distance running. Do you still think this last mile is going to be the hardest part?
Yes, the last mile remains a concern. We are observing a slowdown in the disinflationary process that is typical for the last mile. This is very closely connected to the dynamics of wages, productivity and profits. We had a sharp decline in real wages, which was followed by strong growth in nominal wages as employees are trying to catch up on their lost income. The services sector is affected particularly strongly because wages play a dominant role in its cost structure. At the same time, we've seen a worrying decline in productivity and there's a discussion about what is driving this. One of the factors is labour hoarding, which has happened on a broad scale. Other factors could be the composition of the workforce, such as the integration of less productive workers or a higher share of public sector employment, and possibly an increase in sick leave. The combination of the strong rise in nominal wages and the drop in productivity has led to a historically high growth in unit labour costs.
Does that mean inflation will remain sticky?
The crucial question is: how are firms going to react? Will they be able to pass through higher unit labour costs to consumer prices? This is where monetary policy comes in because it works by dampening the growth in aggregate demand. If demand is held back by restrictive monetary policy, it will be much harder for firms to pass through higher costs to consumers. They will be forced to absorb at least part of those higher costs. This is critical, in particular during the last mile, and we are seeing some evidence that it is happening. But this process is rather protracted and quite uncertain because the economy could pick up more strongly than expected. That could encourage firms to again pass through costs to consumers. In fact, if you look at selling price expectations in services, they have gone up for several months in a row. That’s why recent incoming data do not allay my concerns that the last mile may be the most difficult one. We see sticky services inflation. We see a resilient labour market. At the same time, we see a notable loosening of financial conditions because markets are aggressively pricing the central banks’ pivot. On top of that, recent events in the Red Sea have sparked fears of renewed supply chain disruptions. Taken together, this cautions against adjusting the policy stance soon. It means we must be patient and cautious because we know, also from historical experience, that inflation can flare up again. I'm referring to a recent research paper from the International Monetary Fund, which showed that the flare-up could happen several years after the initial shock.
But there’s little sign of demand picking up in the euro area. The economy is stagnating and has hardly grown for the past year.
The latest PMI survey confirmed signs of a turnaround. We also saw the Citigroup Economic Surprise Index turn positive for the first time in many months. This may be another sign that we have passed the peak of policy transmission, so there is less impact from our restrictive monetary policy. We see that bank lending rates are starting to come down. If you look at online portals for mortgage rates, for example in Germany, you see they have declined quite a bit. I'm not saying that a flare-up in inflation is going to happen. It’s not my baseline, but I think it's a risk we should be prepared for. This is an argument against adjusting the policy stance hastily. We have made substantial progress, and that is good news. But we are not there yet.
Is there now less value and importance attached to models?
Everybody has a model in their mind, whether you write it down in mathematical equations or not. Any policymaking has to rely on models about how the economy works and how our policy decisions affect different parts of the economy. So, models are indispensable.
The recent surge in European inflation was mostly caused by supply shocks, not by demand. When these shocks fade is there a risk Europe could return to the low inflation, low growth environment that we had for much of the past decade?
Let me say first that I do not fully share your assessment of the roles of demand and supply-side shocks. I do think, also in the euro area, that demand played an important role with pent-up demand and the reopening effect. We've seen that over quite some time. So it’s not all supply-side driven.
But let me come back to your question whether Europe is going back to a secular stagnation type of environment. As policymakers, we have to form a view about longer-term developments. And the best way to do that is to think in scenarios. The outcome depends very much on government action. One of the main questions for me is how governments are going to respond to climate change. I see a more benign and a less benign scenario. The more benign scenario would be one where everybody recognises the importance of transforming the economy and doing so relatively quickly, implying that there's going to be a lot of investment, public and private, which is going to push up economic growth. This will probably increase inflationary pressures, as I've explained in several speeches. This could be related to carbon pricing or to the demand for certain metals and minerals. Inflation could also arise from higher food prices due to extreme weather events. Even in this benign scenario, however, you have a countervailing effect on economic growth, because part of the capital stock will become obsolete. But this is still a scenario where you would not go back into a low-growth, low-inflation environment.
The less benign scenario is one in which governments delay the green transition, possibly due to political pushbacks. In such a scenario, there would be a risk that low growth comes back. However, it would be more of a stagflationary scenario with low growth and still relatively high inflation. Eventually, investment would probably need to rise even in this scenario, as economies need to adapt to climate change, but this would come later.
Apart from climate change, there are many other challenges ahead affecting long-term growth prospects. We face a massive demographic challenge. We face geopolitical shifts. And we face changes in globalisation and digitalisation.
All of those factors are relevant for the real neutral rate of interest, or R-star. This measures the real rate of interest at which inflation is at target when the economy is in a steady state. It gives us an idea of where borrowing costs could end up. Do you think the neutral rate has gone up in recent years?
R-star is conceptually very important for the appropriate calibration of monetary policy. The problem is, it cannot be estimated with any confidence, which means that it is extremely hard to operationalise. One could look at market-based estimates. These have typically gone up. But we have to be careful with these market-based measures, because we could be falling into the trap of Paul Samuelson's monkey in the mirror. In a very interesting paper, Sebastian Hillenbrand from Harvard Business School shows that the secular decline in US government yields can be explained by very narrow time windows around the Federal Reserve’s monetary policy meetings. What does that mean? Maybe none of us knows where R-star is going to be. But markets extract information from the public communication of central bankers, rightly or wrongly. Hence, if we look at those numbers that are out there in the markets, we possibly don't learn anything. We might be looking in the mirror.
So what do you think has happened to R-star?
There is a lot of research about the earlier long-run decline in R-star. The global savings glut is often mentioned as one important factor. The question is whether this downward trend may be turning around. I think there are good reasons to believe that the global R-star is going to move up relative to the post-financial crisis period. First, there’s eventually going to be a push globally towards higher investment in response to climate change. We are already seeing this with the Inflation Reduction Act in the United States and the developments in China. I expect a significant increase in global investment, be it for the green transition or adaptation to new climate conditions.
The second reason is government debt. The demands on governments are continuously rising, for example due to higher costs of an ageing population. Another important factor is going to be defence. It looks as if defence spending has to go up a lot. As a result, I would expect government debt to rise, which would also tend to push up R-star. As regards demographic change, an ageing society might lead to more savings, which would push R-star down. But on the other hand, once the population is older, they may actually need to spend part of their savings, for example because they have to finance long-term care, or they simply want to spend their money during their remaining lifetime. There are many other aspects to consider. The process of digitalisation, for example, requires high investments, too. Also, importantly, with less globalisation we should not count on the savings glut in global financial markets. So, overall, I would argue that there could be a turnaround in the trend of R-star.
Why does R-star matter?
What we really care about is the short-run R-star, because it is relevant to determine whether our interest rates are restrictive or accommodative. The problem is we don't know where it is precisely. This implies that, once we start to cut rates – and as I said, we're not there yet – we must proceed cautiously in small steps. We may even need to pause on the way down if inflation proves sticky and the data does not give a clear picture about how restrictive our monetary policy is. Just as we did over the past year, we need to look at the economy in order to assess how restrictive our policies are.
I want to ask you about money supply. You gave a speech on this last year. I know it has been an important focus, and it is close to German central bankers’ hearts. How much of a role does the money supply have on inflation?
First let me say I'm a European central banker and a German citizen. What I showed in that speech is that there is no simple one-to-one relationship between money growth and inflation. This can be explained by looking at two different periods. One is the period after the launch of the ECB’s asset purchase programme in 2015. That was a time when a lot of central bank reserves – base money – were created. But we did not succeed in lifting the economy out of the low inflation environment. Why was that? The reason was that the balance sheets of banks, firms, households and governments were relatively weak. You remember, after the global financial crisis and the euro area sovereign debt crisis there was little willingness to grant loans and to invest. Inflation did not come back as much as the ECB would have hoped.
The other example is the pandemic. By then balance sheets were much healthier, partly due to government support. We had strong loan growth despite the deepest economic contraction since World War II, and inflation came back. The question now is: what is the role of money supply in all of that? One point I stressed in that speech was that the growth in money supply was an early warning sign that inflation may be more persistent. I do believe that it was a mistake to not consider the signals from money growth. It's not a simplistic mechanical relationship. It’s plausible that the broad money supply made it easier for firms to pass through higher costs, which may then have helped to entrench the adverse cost-push shocks. But that is open to debate.
The interesting question is what is happening on the way down? Money growth has been subdued for a while now. Part of that is simply a reflection of our monetary policy transmission, that is the deceleration in lending growth. But there's more to it because we are coming out of a period where money holdings were unusually large because the opportunity costs of holding money were so low. You could simply hold your money as a sight deposit and it wouldn't matter much. But that changed abruptly when interest rates moved up. We've seen quite impressively how people shifted their money into other asset classes.
Has there been a reassessment about the effectiveness of bond purchases as a tool to manage inflation?
I see three objectives of asset purchases. The first is market stabilisation. The second is monetary policy accommodation. The third is monetary policy implementation. Let me start with the first one. There is a broad consensus that asset purchases are a highly effective tool to stabilise markets, and we've seen many instances of that. We saw it during the pandemic. We saw it in the gilt market stress episode in the UK in the autumn of 2022. And it is also the logic behind the ECB’s Transmission Protection Instrument. The idea is that when you face market disturbances, asset purchases can instil confidence at a time when markets can’t coordinate. What then matters is the flow of asset purchases over a short period of time. We saw in the UK example that these types of purchases can be reversed relatively quickly. And then they're a profit-making activity, because central banks buy assets when nobody else wants to buy them and sell them when the prices have recovered.
Second, monetary policy accommodation. The views here are somewhat more dispersed. What is clear is that quantitative easing is an important tool when the economy is at the effective lower bound at which further interest rate cuts are no longer feasible. They then work by compressing the term premium, that is mainly via the longer end of the yield curve. What matters here is not the flow of purchases but the stock of bond holdings. This is why it is the announcement of new purchases that plays the key role. But the success of these programmes is not guaranteed. As discussed before, the ECB’s asset purchases before the pandemic were not as successful in bringing inflation back to our target as we would have hoped, because their effectiveness depends on the economic environment. At the same time, they have side effects. They have an impact on market functioning, fiscal discipline and financial stability. And given that it's not so easy to reverse them, they may be a loss-making activity a long time after the purchases have been conducted.
Shouldn’t central banks ignore these losses?
We shouldn't be structurally loss-making over longer periods of time. Losses may at times be unavoidable if required to preserve price stability – that's correct. But we cannot ignore the potential reputational and credibility effects that come with losses. This is something we need to keep in mind.
And the third objective?
The third objective of asset purchases is monetary policy implementation. It means we can use asset purchases to structurally provide liquidity to the financial system through a structural bond portfolio. Of course, one has to think about how to calibrate the size and the composition of that portfolio, which goes back to the side effects I mentioned earlier. Maybe you don't want it to be too big. And when you are concerned about interference with the monetary policy stance, you may want to focus on shorter maturities. Overall, asset purchases are an important part of our toolkit, but we should use them wisely and in a proportionate manner so that we are sure that the benefits outweigh the costs.
It actually changes over time. The size of the balance sheet depends on many factors, including the macroeconomic environment. But there are two main structural determinants of the balance sheet. First, the autonomous factors, the most important part being the amount of banknotes in circulation, plus required minimum reserves. Second, the demand for excess liquidity by the banks, which has increased significantly, partly due to new regulation. This demand also depends on the operational framework we are in, which we are discussing at the moment. If holding liquidity is costly, banks will economise on liquidity, which would lead to a smaller central bank balance sheet. We plan to publish the outcome of our operational framework review in the spring. Our framework will be tailored to the specific features of the euro area financial system, which is strongly bank-based and has a lot of heterogeneity. It's important to stress that this framework will have no direct implications for the process of quantitative tightening, which will continue to gradually proceed in the background.
What are the lessons you draw from the last three or four years?
What I’ve learned is that we shouldn't believe that the world tomorrow will necessarily be similar to the world today. It can change very quickly. I would like to tell you an anecdote. When the book “The Great Demographic Reversal” by Charles Goodhart and Manoj Pradhan came out, we were in the middle of the pandemic. Inflation was falling and turned negative in the second half of 2020. We had experienced too low inflation over many years. Everybody was concerned that inflation would remain low or drop even further, while interest rates were already at the effective lower bound. Then the book came out and said that the real threat is too high inflation and not too low inflation. I remember that I discussed it with some people and the reaction was that this should be disregarded because it was not relevant at the time. I believe it would have been wise to listen to an economic historian like Charles Goodhart, who has seen the world changing many times. The problem was that we were so caught up in our thinking and this also influenced our policy reaction. We tied our hands too strongly by forward guidance and the way we intended to sequence the end of our policy measures. I think this is the main reason why we were a bit late on both ending asset purchases and hiking interest rates. So going forward, we should maintain more flexibility. If we ever went back to forward guidance, it should be of the Delphic type, which is a forward guidance conditional on economic data, but not the Odyssean type, where you tie yourself to the mast figuratively speaking.
We've also learned something about the reversibility of policy measures. Once we started, we moved from a deposit facility rate of minus 0.5 % to a rate of 4% very quickly. This took a little more than a year. We are also moving out of the targeted longer-term refinancing operations pretty quickly because they have a fixed maturity and because of the possibility of early repayment. The absorption of that has been very smooth. But what is much harder to reverse is the big stock of asset purchases. You have to be very gradual in doing that. This creates a big legacy for the future. And this is something that we need to discuss.