Interview with Il Sole 24 Ore
Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted by Isabella Bufacchi
11 January 2022
Euro area HICP inflation in December hit another record all-time high. Maybe a peak. Markets are now even more convinced that the ECB is going to raise interest rates at the end of this year. Is this data going to derail your monetary policy stance?
In our December projections we assessed that inflation at the end of 2021, including in the month of December, was going to be high. But we also believe that inflation will fall this year, and that it will go below our 2 per cent target in 2023 and 2024. This is driving our monetary policy assessment. We are looking beyond the inflation we have right now: monetary policy is based on the medium term.
European citizens are paying more for food, petrol, electricity. How far can the ECB tolerate prices shooting up? Is inflation really only “moderately” higher than your target?
The 5 per cent inflation number in December is unusually high. This is dominated by the fact that energy went up by 26 per cent last year. The key issue for us as the central bank is: do we see changes in household and firm decisions? Do we see changes in wage behaviour? But we do not see behaviour that would suggest inflation will remain above our target into the medium term.
Did you expect inflation to be so high in December? Was 5 per cent in the Eurosystem staff projections at the time of the December Governing Council meeting?
It is within the margin of error of what we expected. We knew we would have a concentration of price pressures at the end of 2021, especially the big surge in energy prices. This is visible in the December data, but the basic narrative remains in place.
By this you mean that interest rates are not going to go up this year?
This goes back to our December assessment that inflation will not only fall this year but will settle below our target in 2023 and 2024. The criteria for moving interest rates up are therefore not in place. This remains our view. As the year goes by, we will have more data and will continue to assess the situation.
Many market players still expect the first interest rate hike in the euro area at the end of this year: is there a problem of communication?
The data we have, make it quite unlikely that the criteria we set to raise interest rates will be fulfilled this year. Next year and the year after that, the same criteria will apply: these criteria are very clear and the market can study them. But let me focus on one element, we have a cross-check: to raise interest rates, we need to see sufficient progress in underlying inflation. The pandemic makes it more difficult to interpret indicators of underlying inflation. It will take some time to filter out the effects of the pandemic – base effects, supply bottlenecks and so on − and to have a proper assessment of what is going on with underlying inflation. We have highlighted on a regular basis that the central element in understanding underlying inflation is to find out what happens to the trend in wages. We will be looking at wage settlements throughout the year. Behind prices are costs, and the most important cost in the economy is wages. Labour costs are a big part of the overall price level, and labour costs tend to move on a more persistent and more gradual basis. Energy moves are abrupt, energy can go up and down in a volatile way. But a significant move in the persistent and underlying source of inflation is unlikely unless you see wages picking up quite a bit. Until now, the wage data do not indicate any major acceleration in underlying inflation.
US core inflation is expected to be 2.7 per cent this year. The Federal Reserve said it will raise rates “sooner or at a faster pace”; three hikes are expected in 2022 and three in 2023. The ECB rates are on hold. Does the euro area risk importing inflation with a weaker euro and a stronger US dollar?
It is important to see foreign exchange as part of the pandemic cycle. In 2020 we had a euro appreciation. In recent months, some of that appreciation was reversed. Compared to pre-pandemic levels, we had an initial appreciation of the euro, and now a depreciation. It is not a major element. I would not overly focus on the exchange rate.
Why is the ECB monetary accommodation being extended while the Federal Reserve and the Bank of England start tightening? Why is the ECB so far apart?
There is a crystal-clear difference. In the United States and the United Kingdom, the assessment is that inflation will not stabilise at the target of around 2 per cent unless there is a monetary policy tightening. The discussion about monetary tightening there depends on the assessment that inflation will remain above target: then monetary tightening is considered necessary. Our assessment for the euro area is different − inflation is expected not only to go back to the target but also to fall below the target − therefore our monetary policy reaction is different. This is the key issue.
It is crystal clear, but there is also confusion due to exceptional factors – the pandemic and bottlenecks – that are having an impact on inflation, with no historical parallel that can be made.
It is important to recognise the pervasive impact of the pandemic on inflation. Look at the three pandemic years, that is, 2020, 2021 and 2022. In 2020, we had low inflation or even disinflation. And this was one of the motivations for us to react with the pandemic emergency purchase programme (PEPP): inflation was too low. The ECB has a symmetric view: too high inflation and too low inflation are equally undesirable. In 2021, the world economy and the European economy recovered more quickly than expected. There was a fast recovery driven by vaccinations, demand was strong and supply could not keep up due to bottlenecks. In the initial stage of the pandemic, some countries reacted with special measures, such as the VAT cut in Germany, which drew up prices when it was reversed in 2021. We have a lot of special factors that are leading to unusually low inflation in 2020 and unusually high inflation in 2021. I see 2022 as a transition phase, gradually going out of the pandemic. The high pressure on inflation in 2021 will be fading this year, but 2022 is still part of the pandemic cycle. And when the pandemic is over, in 2023 and 2024, inflation will stabilise at a lower level, at about 1.8 per cent, which is much closer to our target compared to what we had before the pandemic. Inflation is not just going back to its pre-pandemic level. We have made progress by providing monetary policy support and fiscal support. The economic recovery in 2023 and 2024 in the euro area will bring inflation closer to our target.
Is the economic recovery solid in the euro area and in Italy? Can bottlenecks jeopardise the recovery?
Bottlenecks are another temporary factor: if there is a shortfall in production today, it means there is going to be more production later on. The order book is very good. Overall, in Europe we see a solid growth engine this year, next year and the year after that. This applies also to Italy. First, there is the bounceback from the pandemic. Italy was hit very hard in 2020 and it had a strong recovery in 2021, even if some sectors, such as tourism and travel, are not back to normal. Next Generation EU (NGEU) is another engine for growth and Italy is amongst the primary recipients. This is where I see the difference between the pandemic and the great financial crisis: we now have medium-term growth engines − NGEU will last for several years. Moreover, this time the banking system provided support for the recovery. The banking system is stronger. Now, there is more support for the recovery.
Italy’s growth is solid, but the BTP-Bund spread is widening, in spite of more flexibility in PEPP reinvestments to intervene against fragmentation. The ECB has always found instruments to intervene against fragmentation: the Securities Markets Programme, Outright Monetary Transactions, then PEPP net purchases: but why is flexibility now only in PEPP reinvestments?
In December, the Governing Council decided to end net purchases under the PEPP in March and to use PEPP reinvestments in a flexible way if needed. But to provide total clarity, we also considered it a good idea to remind people in more general terms that our mandate is price stability, and that on some occasions, to deliver our mandate, we have to use instruments and programmes that can be flexible to counter fragmentation. So in December we also said that if there is a threat to price stability, and this threat is fragmentation, under stressed conditions we will implement monetary policy in a flexible way. This is quite straightforward. It is a restatement of what the ECB needs to do: the ECB cannot always run monetary policy in a mechanical way in the euro area, where 19 countries adopt a single monetary policy. What is important is that we reiterate our flexibility when it is appropriate. And then we have the specific reminder that, as we move into the next phase in the recovery, we said we have a mechanism, PEPP reinvestments, by which we can deal with fragmentation risk.
The Federal Reserve will reduce its balance sheet after the first interest rate hike. The PEPP’s portfolio will be reinvested until 2024. And the asset purchase programme is still open-ended. When will the ECB balance sheet shrink? When will banks repay the targeted longer-term refinancing operations (TLTROs)?
With the TLTROs, the decisions are driven by banks: so long as TLTRO funding is available, it is up to banks to decide whether to replace TLTROs with funding on the market. As for the ECB balance sheet, there is a clear sequence: net purchases stop before the first interest rate increase, and only well after the first increase in interest rates will the central bank think about shrinking its balance sheet. This principle is valid for all central banks, it is fairly universal. But the ECB is further away from increasing interest rates than some other central banks. So the debate on when to start shrinking our balance sheet is also further away; the shrinkage of our balance sheet is much more a topic for the future than for today.
Asset purchasing is linked to interest rate hikes. The last ECB interest rate hike was more than ten years ago, in 2011: a rate hike could take markets by surprise. Is the ECB worried about price correction and asset valuation triggered by monetary policy tightening?
Investors, academics, they all know very well that in a world of low interest rates, rates eventually go up and there are implications for asset prices. Any bank, insurance company or pension fund will allow for this risk. Regulators and supervisors also think a lot about this. So it will not come as a surprise that at some point in time rates, short-term rates or long-term rates, will go up. But I also disagree that monetary policy has a significant surprise element. This is in contrast to major financial crisis episodes, for example what happened in September 2008, which came as a big surprise. It’s important for central banks to be clear, to be predictable. And I think we are very clear on interest rates and we are very predictable. The world can adapt to higher rates, and many institutions will already have allowed for this risk in their planning.
My last question is not on interest rates or monetary policy but on your very detailed proposal for the reform of the Stability and Growth Pact. Can you give your thoughts on the reform?
Let me give some initial suggestions at a personal level. One topic is that the fiscal framework should combine debt sustainability with fiscal countercyclicality. Fiscal policy must be sustainable in the longer term, but it should not aggravate the business cycle by loosening during expansion and tightening during recession. For debt sustainability, I agree we must see high debts coming down. But in a world of low rates, maybe an adjustment path can allow for a more moderate pace of reduction (for example, at 3 per cent per annum rather than the current 5 per cent). A second point is that the inflation element could be incorporated in the fiscal framework: fiscal policy has a bigger multiplier when interest rates are low and when inflation is low. But the debate has just started, it is early days, these ideas will be part of the debate in the European institutions.
Some proposals have been made, going as far as asking the ECB to sell its government bonds to specific buyers: would this be possible?
There is an important separation. The fiscal framework is for Member States and the European Union to decide. We are clear in our strategy: our monetary policy and our balance sheet is driven by price stability and by what is needed to stabilise inflation at our 2 per cent target. The fiscal framework cannot imply any particular imposition on the ECB. Fiscal policy matters a lot to the ECB. But there is a clear separation between fiscal policy and monetary policy.