Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted by Luke Heighton on 16 November 2022 |
We’ve done a good amount of monetary policy normalisation, says Chief Economist Philip R. Lane in an interview with Market News. We will continue to raise interest rates until we’ve reached a level that will make sure inflation comes back to our 2% target in a timely manner.
What do you expect December’s Eurosystem growth and inflation projections to show?
The staff projections are going to cover 2023, 2024 and 2025. I think for 2023 the teams involved would have to take into account a number of factors. Number one, inflation is higher now than was expected in the last round. So the starting point for inflation is different compared to the last round. Over the course of the autumn it has become clear that next year energy prices are likely to remain higher than previously expected. Even though a lot of gas has been stored and we’ve had mild weather so far this winter, it’s accepted that, based on the current outlook, the risks about gas supply are also going to be here next year. I think it’s also clear that, at least in some countries, the pass-through of high energy wholesale prices to retail prices is not over. So we will see more of that. And in terms of fiscal policy, it looks like fiscal deficits are wider than foreseen in the September projection. So there is more fiscal support for the economy next year and that has inflation implications.
For the medium term, looking into 2024, 2025, I think there are really two big issues. One is that it’s clear that wages are set to increase more strongly than normal. We already saw in the September projection that there will be several years of nominal wages growing more quickly, because workers have experienced a significant loss in their real wages. We do expect this kind of catch-up process to drive nominal wages higher over several years. And, as we already had in September, there will have to be a kind of reassessment of the wage outlook in the context of the higher inflation rates, the status of the labour market and the fiscal support that is still there.
The other factor that’s going to be relevant for 2024-25 is the feedback loop. There’s been a big jump in the yield curve and it’s starting to pass through to bank lending conditions. Even if this does not have an immediate effect on the economy and on inflation, we would expect to see it kicking in more strongly in 2024 and 2025.
So for those years the forecast will have to balance the fact that inflation has a knock-on effect, for example, on the wage mechanism. But on the other hand, we do have the fact that the financial conditions are far different than what we had going into the September forecast.
A number of Governing Council members have recently expressed worries about second-round effects. How much of a concern, in terms of the inflation outlook, is pay growth?
This year we’ve had a very large increase in the price level, so there’s been a very big drop in living standards. At the same time unemployment in historical terms is quite low. So even if the European economy experiences stagnation or a mild recession later this year and at the start of next year, it still has quite a lot of support for ongoing growth. Even if the energy shock levels out next year – so it’s no longer a source of inflation, and even if globally bottlenecks are easing – so the pressure from global commodity prices and global goods prices also levels off: there’s still going to be an inflation dynamic in 2024-25.
Labour costs are a big fraction of the domestic component of inflation. But then the question is: how long is that going to be for? And as I said earlier on: it’s going to be stronger than the historical average, because workers will be trying to rebuild living standards. But how much and for how long labour costs will contribute to domestic inflation remains open and is a source of high uncertainty. There will be some calculation in the December projections, but month-by-month, quarter-by-quarter, over the next year, this is going to be one of the key issues we’re going to watch. I don’t think we’re going to have a conclusive answer next year.
But there is a very important feedback loop here, which is also relevant for the decisions by firms. We’ve done a good amount of monetary policy normalisation, and we gave a clear signal that we will continue to raise rates until we have reached a level that will make sure inflation comes back to 2 per cent in a timely manner. Firms and workers should understand that price and wage-setting should take place in the context that the more expensive financial conditions will dampen demand next year and in the years after that. Firms should be careful about excessively raising mark-ups, and workers should be careful about what a sustainable wage increase is. There is an important interaction between what we do and how these price and wage decisions are set. Another way of saying this is that firms and workers should fully understand that inflation is going to come down over these years towards our 2 per cent target.
What would you need to see to recommend raising rates by 75 basis points in December? Conversely, what would justify a smaller rate hike?
We said in our recent meetings – and we did so again in October – that we expect to raise rates further. It’s usually neither necessary nor wise to try and jump immediately to your target rate. In December we will make another hike and the scale of it should continue to make progress towards the levels needed. But it’s not necessary to conceive completing that transition in December. Each meeting is different. But one platform for considering a very large hike, such as 75 basis points, is no longer there. When we were at zero, that did not correspond to anyone’s idea of the interest rate level necessary. Going to 1.5 per cent is still below where we need to go. But the more you’ve already done on a cumulative basis, that changes the pros and cons of any given increment. We will have to look at it in terms of the inflation outlook that we have in December and take into account that we are at a different point now, and also to recognise that there are lags in the transmission process.
Would increasing rates above 2 per cent in December offer greater scope to slow the pace of interest rate hikes in the first quarter of 2023?
I am not going to comment on the exact level at any one meeting. Clearly, there’s a connection: the higher the level of the interest rate, the smaller the remaining gap to the target rate. What matters is the level we’re going to arrive at. The exact allocation across different meetings is a secondary issue. But the more we’ve already done, the less we need to do.
How likely is it that the ECB will stop – or pause – the hiking cycle either before or at the point when it begins quantitative tightening (QT)?
I don’t think December is going to be the last rate hike. Trying to jump forward to February, to March, to May or June next year, I think it’s too early to have very strong views at this point. The logic of a pause for the ECB: we’re not at that point. The more relevant argument than whether to pause is to move at the appropriate time to smaller increments. And then, eventually, you get to a point, where, essentially you say: okay, we’re at the level where it’s probably going to be wise to hold at this level for a while but also signal that we will be open to do more if needed, because we are living under high uncertainty.
Then let me come to the second part of your question, about QT. We shouldn’t interconnect the issue so much. What is clear is that you want to make decent progress on raising the policy rate before you start mapping out QT. And by December, we will have made decent progress on that. We said that we will lay out a roadmap, general principles in December. The roadmap will subsequently convert into a more precise plan that will allow for the asset purchase programme (APP) portfolio to decline at a certain pace in the coming months. But I don’t think we’re going to be on a meeting-by-meeting basis interconnecting the interest rate decision with the pace for the next month or two. It should be probably more mechanical than that. I think that’s a pretty basic principle.
By how much would you expect QT to lower the terminal rate of interest?
I wouldn’t approach the question like that, because there’s no scenario in which we keep the APP at its current level. Of course, if you don’t scale down the APP portfolio, the policy rate would have to be higher – there is a substitution effect there. But the market does expect some degree of runoff of the APP, and that is already reflected in the yield curve. So the calibration of the APP schedule has to perform two objectives. One is to contribute to the overall stance by essentially reversing the kind of compression of term premia that quantitative easing (QE) did; and the other is to make sure that this is done in an orderly way, because we have to allow for the market to adjust.
The ECB has said that the expected shallow eurozone recession will not in itself be sufficient to bring inflation back to target. What is the sacrifice ratio that would?
We have to remember where we are. There’s going to be a fairly large reduction in the inflation rates simply through base effects. But even if that reduces the inflation rate, it still leaves the cost of living permanently higher. So the price level is very important for wage dynamics. Going back to the monetary policy issue, we have to think about where inflation is headed in 2024-25 and what the distance is to our 2 per cent target. We also have to take into account what’s already happened. The yield curve is higher, we see adjustments in bond markets and we see bank lending rates going up. More expensive financing conditions will mean a lower level of demand. That will mean a lower level of GDP and a lower level of employment. But the labour market has two margins at the moment: one is unemployment, the other is vacancies. You could have a slowdown in the economy, where one part of adjustment will be fewer vacancies. And with fewer vacancies, wage pressure will go down. And if you don’t have the option to move to a new job, then wage bargaining changes. It could also be the case that firms opt to hold on to workers and there is a degree of labour hoarding. Under those circumstances unemployment may not rise as much as in previous cycles. I would say we would expect unemployment to go up as well, that is true, but in the context of levels that right now are historically quite low.
Your colleague Mr Panetta warned earlier this week that the ECB must be alive to the dangers of excessive tightening, which he said could result in a permanent loss of output in response to persistently lower demand. Do you agree?
We are absolutely clear and we have a primary mandate that we will get to our target in a timely manner. But it has always been the case and always will be the case that we want to do it in a way that minimises the side effects in terms of lower output and higher unemployment. The history of recessions does indicate that they tend to leave a long-term footprint. But what’s also true is that there’s an appreciation that the balancing act requires us to avoid under-tightening. Because if you under-tighten, inflation remains too high for too long, and then in turn you may end up having a bigger recession later on, with a bigger permanent drop in output.
We currently do think that any recession will be mild and short-lived. But you can definitely construct scenarios where that recession gets bigger and longer. And if you have rising credit risk, then you will have financial tightening coming from the decline in the economy, and that will be important. Financial conditions in the euro area also interconnect with financial conditions globally. And with other central banks also tightening, you’d have to think about that spillover. If tightening in the rest of the world leads to lower global inflation pressures, lower commodity prices, lower pressure on tradeable goods prices, then the inflation forecast could improve for international reasons in addition to domestic reasons. This all goes back to why we are taking a meeting-by-meeting approach. We are giving a kind of directional orientation that we have more to do. But in terms of the exact scale of what we need to do, it would be a mistake to be overly fixated in either direction.
How happy are you currently with financial conditions across the eurozone?
What we see this year is a sharp change in the inflation outlook, which in turn led to a sizeable revision in monetary policies around the world. And, of course, the whole financial system is going to take time to absorb that. We would call on everyone to recognise that we’re in a new environment and to manage those risks. I was involved myself in previous reports about what happens if you move away from the low-for-longer environment, so I think that the risk factors are clear. But in terms of where we actually are, I think the adjustment so far has been very much within the lines of reverting to normal rather than creating historically tight conditions.
Has the LDI fiasco in Britain affected your thinking in any way?
Maybe it sends out two signals: I think there’s a clear message for governments everywhere that it’s very important to have fiscal strategies that are clearly anchored in debt sustainability and in making sure debt ratios are on a downward path. Second, we have to be vigilant for pockets of the markets that may have been taken by surprise. But let me again emphasise here that what we have is a kind of smooth adjustment so far to a very different environment.
The European Commission is currently in the process of renegotiating EU fiscal rules. What bearing, if any, does that have for the outlook for monetary policy?
Before the energy shock, this year the Commission would have forecast a pretty big drop in debt and deficit ratios in the coming years. There has been an improvement this year because a lot of the pandemic programmes have been stopped and we’ve seen the recovery in the economy, which has boosted tax revenues. This has allowed a lot of energy programmes to be launched, a lot of which are temporary in nature. One of the big issues, I think, for the coming year, is to make sure that these interventions are temporary and targeted, and are basically embedded in a larger strategy of making sure debt ratios, especially for the high-debt countries, are firmly on a downward path. I think everyone shares this analysis. But what is true is that having fiscal deficits that remain relatively high will support demand in the economy and add to medium-term inflation pressures. Everyone has to really look at this quite carefully, because a lot of the fiscal programmes right now are basically transfers to households or to firms. And the multiplier on transfers is lower than on government consumption or government investment. A lot of people who receive these transfers may just save them, so it’s not clear whether it will result in the same boost to aggregate demand.
Last week the ECB changed its collateral rules, which saw asset swap spreads tighten. How much does this solve the problem?
I think there are three factors here. One is the increase in our securities lending facility. The second is: the German debt management office has also announced measures. And the third is the targeted longer-term refinancing operations (TLTROs) decision we took in October, which will also release collateral back into the system. Of course, we’ll always be attentive to market functioning and collateral scarcity issues. I would mention, also, that governments will still be issuing quite a lot of debt, and we’re not going to be net purchasers, so the amount of collateral coming into the market from that source will also ease pressures.
So there shouldn’t be any need, for example, to issue short-dated paper to relieve a year-end collateral squeeze?
We will always be vigilant, but I think the measures we’ve put in place will be sufficient.
Banks are pushing for the ECB to set up reverse repo operations, yet so far the bank has been hesitant to do so. Why? Is it under consideration?
First, the ECB always thinks about everything all the time, so there’s no informational value in saying something is “under consideration”. The ECB always has a range of options for how it can manage its liquidity but I think the decisions we made last week will suffice. Also, we always have to think about the differences between the euro area, which remains very decentralised, and the American financial system. The Fed has a particular approach, but it’s not necessarily the best approach for us.
Does the lower-than-expected US October inflation print have any bearing on expectations for the eurozone HICP outlook?
One month of data does not constitute a trend, so let’s be cautious about this, we need a longer horizon. But if it turns out to be the case that there is a trend, there are basically two forces behind it. One is a decline in global inflation pressure, which will also benefit the euro area by lowering pressure on import prices. The other element could be a decline in domestic inflation. And we saw that, in fact, services inflation came down as well. That could suggest that the United States is now making progress in its adjustment, and of course that would be good news for the world economy and for us.
The German ZEW survey has just recorded a substantial rebound in expectations, although the outlook is still in negative territory, largely on the back of hopes that inflation will fall in the near future and monetary tightening will not be as severe as initially anticipated. Is this optimism justified?
A lot has been done to preserve energy supplies this winter, whether that’s the filling up of gas storage or many firms – and indeed many households – reducing energy consumption. Clearly, compared to worst-case scenarios, this has led to a degree of confidence building for the near term. On our side, I do think that what we’ve done has helped – in the sense of ending the QE programmes and the by-now sizeable and repeated increases in policy rates – the actions we take demonstrate that there will be downward pressure on inflation.
Then you come to the near term and that’s where we should take into account that there is a lot of inflation pressure remaining in the pipeline, but this differs across countries. In some countries, Spain for example, energy inflation may have come down primarily because a lot of the adjustment happened a year ago. For other countries with longer-term contracts for energy, the pass-through to retail prices is ongoing. Sooner rather than later, the accumulated pass-through will convert into downward pressure on inflation, but let’s see whether the peak turns out to be this side of Christmas or the other.
So we might see, for want of a better word, some choppiness in near-term inflation expectations?
Around March, after the war started, there was a pick-up in consumer expectations. But they have been relatively stable in recent months. They haven’t improved, but they haven’t deteriorated either. I would say that these days my focus is on three levels. Historically, there would have been a kind of differentiation between short term and long term. But actually, I think the medium term is quite important. I do think, by and large, across all types of surveys and market indicators, people believe that over a longer horizon, inflation will get back to 2 per cent. People also understand that in the near term, over the next number of months, inflation is going to be elevated compared to our targets. But the important issue for us is the two-way feedback loop between medium-term expectations. Where do people think inflation will be in 2023, 2024, 2025? That will influence pricing decisions and wage decisions, while also recognising that these medium-term inflation expectations clearly will also be influenced by our decisions.
Across the euro area, corporate profits are soaring at the same time as an increasing number of households and businesses are struggling.
There isn’t a universal message here. In some sectors, where demand was surprisingly strong this year, it is clear that one major source of inflation was not cost increases: it was firms responding to high demand compared to supply by raising mark-ups. A second category is clearly some types of energy firms which are generating windfall profits. There’s a third category of firms which are suffering because they have very high energy bills, demand may not be particularly strong, and for those firms the profit margins are being squeezed. The message here is not so much for those firms but for the firms where mark-ups are currently high. These firms should be paying attention to the macroeconomic situation, to our policy, to the fact that demand conditions will be tighter next year. I am thinking about the tourism industry, for example, or the restaurant industry, all sorts of industries, which benefited from reopening this year. It will be very important to recognise demand conditions will be tighter and it would be a mistake to seek to preserve very high mark-ups in that scenario.
Compliments of the European Central Bank.
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