“I would be in no hurry to cut interest rates”
Mr Knot, let's go straight into medias res and start with the crucial question: Who will win the European Football Championship in 2024?
That's a tricky question! I'm afraid it won't be Germany or the Netherlands. For me, France is the big favourite. We lost to them twice in the qualifying group and now have them as opponents in the group stage. So we're a bit unlucky in the draws.
And to build a bridge to monetary policy: Euro 2024 starts on 14 June – one week after the ECB meeting in June. Will the ECB have cut interest rates by then, as many expect?
I'm not going to give you a concrete answer. Because it's still far too early to be that specific. Yes, the latest inflation figures were a very welcome confirmation that we are on the right track to bring inflation back down to the target level of 2%. But we have to wait and see how wages develop before we can say that inflation has also turned the corner durably. Our projections are based on a clear deceleration in wage growth and profit margins in 2024.
But that is uncertain?
There will be new wage agreements for 40% to 50% of all European employees at the beginning of 2024. This will be very important information for us. This information will not be fully available until around the middle of the year. And why should we, as evidence-based decision-makers, front-run such important information?
So from today's perspective, you would consider it rather unlikely that key interest rates will be cut in the first half of 2024?
Based on the information available today, I think it is rather unlikely. But we are data-dependent and not time-dependent. We have to get inflation to 2% by 2025 – that's crucial. And a lot has to go well still for that to happen. So we have to remain vigilant.
But the rate hike cycle is definitely over?
I would disagree with the word "definitely". Based on current information, I don't see any urgent need for further interest rate hikes. We can be satisfied with the current monetary policy stance. But the wage data can go either way and then we may have to react accordingly. So, although quite unlikely, I wouldn't categorically rule out further interest rate hikes just yet.
Before the publication of the November inflation figures and the fall from 2.9% to 2.4%, a number of central bankers had not ruled out further interest rate hikes. Now the discussion is almost exclusively about interest rate cuts. Was the data a game changer?
I am always careful with such terms. But the November inflation data was good news in the short term. And not just because of overall inflation. Much more important was the fall in core inflation from 4.2% to 3.6%. This decline was also stronger than expected. But we have a medium-term orientation. And I am happy to repeat myself: there is still one important piece of information missing. There is still no turnaround in wages. And we will have to see some good news from the wage front before we can say that inflation has also durably turned the corner.
However, the markets continue to bet on early and aggressive rate cuts by the ECB in 2024 – starting as early as March.
It should be recognised that the disinflation path we are assuming in our new projections is based on financial conditions that involve significantly less policy easing than is implied by current market prices. So if current market prices continue to deviate from this path, this in and of itself represents an upside risk to our December inflation outlook. That is the first important observation. And on the market dynamics themselves: Markets always tend to be optimistic at the end of the year, often followed by a hangover in January.
So the optimism about rapid interest rate cuts is exaggerated?
Year-end optimism may be affecting the assessment of incoming data. We have run many simulations of the optimal monetary policy path based on our current assessment of the inflation and economic outlook. And I can assure you that the optimal monetary policy path that emerges from these simulations is much closer to the policy rates that were priced in at the cut-off date of our projections than to the policy rate path that is priced in on the financial markets today – after the November inflation data.
You have described market expectations and the consequences for financial conditions as an upside risk for inflation. How do you assess the overall risk balance?
I would say that the upside and downside risks to inflation are roughly balanced in the short term. In the medium term, for the years 2025 and 2026, I see risks slightly tilted to the upside.
How happy are you with the new projections, which predict 2.1% and 1.9% inflation for 2025 and 2026? In previous years, the projections were often way off the mark.
The projections for 2023 have been remarkably accurate. In addition, inflation is really coming down. These two facts together show that we are getting a better grip on inflation again. I am confident that the return to 2% inflation in 2025 is a credible prospect.
And you're not too worried about the euro economy?
The fourth quarter is likely to be weak again and the first quarter of 2024 won't be great either. But in the medium term, there are factors that give us confidence. Real wages will increase in 2024 and boost purchasing power. And the labour market remains strong. The combination of these factors forms a credible basis for an upturn in 2024. The economy has also proven to be very resilient. The damage we are doing to our economy through higher interest rates is extremely limited compared to previous disinflation episodes. This is another reason why I would be in no hurry to cut interest rates. Any eventual withdrawal of monetary policy restriction can and must be gradual and patient.
And you don't fear a credit crunch?
The decline in lending is a feature of our policy, not a bug. Of course, we have to monitor this closely. But so far we don't see any danger of financial amplification effects that might lead to a real credit crunch. The banks in the Euro area have proven to be very resilient and are in a good position. They are well capitalised and profitable.
Some see it differently and argue that the ECB has already gone too far with the tightening.
Given the inflation outlook and how I see the risk balance, I beg to differ. That doesn't mean we should be blind to the possibility of excessive tightening at some point in the future. But we must not let our guard down either, as our President Christine Lagarde has said. I fully agree with her that a premature declaration of victory is still the dominant concern.
In the US, Federal Reserve Chairman Jerome Powell recently warned of the risk of holding on to high interest rates for too long. But for the Eurozone, would you say it is better to play it safe?
I will look at the data every six weeks and weigh the two opposing risks: the risk of a premature declaration of victory over inflation versus the risk of excessive tightening. As far as the comparison with the US is concerned, you also have to realise that there are major differences.
What exactly do you mean?
The structural feature of staggered wage settlements, which we have in Europe and which barely exists in the US, implies that wage developments cast a longer shadow over inflation developments in the Euro area. This means that we probably need to put more emphasis on the duration of the restriction than on the other side of the Atlantic. In the US, wages are already falling and productivity is picking up – which also helps the Fed. In the Euro area, on the other hand, growth in unit labour costs is still at a record high.
Speculation of rapid interest rate cuts was also fuelled by the decision to gradually phase out reinvestments in the PEPP coronavirus emergency bond purchase programme from mid-2024 – earlier than previously planned. This is seen by many as a restrictive stimulus for which some kind of compensation may be needed.
This is a misconception. PEPP tapering is more about monetary policy hygiene than about the monetary policy stance. The pandemic has officially been declared over, and it was no longer proportionate to continue reinvesting in full. We therefore wanted to gradually and predictably reduce reinvestments. But the impact on interest rates is minimal.
Some critics say that the PEPP tapering comes at an inopportune time because the EU fiscal rules are due to take effect again in 2024 – which could cause problems for some countries.
Quite the opposite, I would say. Compliance with jointly agreed fiscal rules bolsters fiscal credibility and thereby helps removing any lingering doubts about debt sustainability. We only have a role to play if markets are dysfunctional resulting in an unwarranted rise in bond yields.
Will the end of the PEPP reinvestments increase the likelihood that the Transmission Protection Instrument (TPI) launched in 2022 will have to be activated?
The markets are completely calm and orderly. Spreads came down upon our PEPP announcement. There is currently no risk of fragmentation.
But experience shows that this can change quickly. And then?
I am counting on our finance ministers to agree on new fiscal rules that will strengthen the credibility of fiscal policy. And that will help ensure that the bond markets remain relatively calm and orderly.
Not everyone shares the confidence that such an agreement will be reached – at least not in the short term.
There will be a last ditch effort this week. I am confident that it will succeed. Credible fiscal policy rules are essential in order to pursue a stability-orientated monetary policy.
In your view, has fiscal policy in the Euro area actually done enough to support monetary policy in the current fight against high inflation?
So far, fiscal policy has not really helped monetary policy. But if you look at our current projections, we have managed to create a credible prospect of a return to price stability in the medium term, despite fiscal policy pursuing different objectives. Nevertheless, a sufficient degree of fiscal consolidation in 2024 would be very welcome. Politicians should also do this out of self-interest. They are running out of time to adjust their primary balances to the structurally higher interest costs that they will have to bear in the future. So far, budget consolidation exists mainly on paper. We will have to wait and see whether it is actually implemented.
What do you think of the proposal to increase the minimum reserve ratio from the current 1% that banks have to hold for customer deposits at the ECB? Would this reduce excess liquidity?
Our mandate is price stability rather than increasing our profitability or envying the profitability of the banking sector. We should therefore discuss this issue as part of our review of the operational framework. A limited increase might make sense. However, we should also not destabilise liquidity risk management in the banking sector by rushing through changes to the minimum reserve requirements.
What should the key elements of this future framework look like?
The system should definitely be demand-driven. The EU treaty stipulates that we should continue to operate in accordance with the principles of a market economy and hence reduce our footprint on the markets as much as possible. I have not yet decided whether this should be a demand-driven floor or a narrow corridor. But I think we should be able to react flexibly to the demand for liquidity. A mix of instruments is ideal. However, because of its greater agility I believe our most important instrument should be refinancing operations.
Do we need a structural bond portfolio in the long term?
A structural bond portfolio is one of the ways through which we could provide liquidity. I haven’t really made up my mind yet on how much room I see for this instrument. But if it were to be such a portfolio, it should be as small as possible. Also in view of Article 123 of the EU Treaty, the prohibition of monetary state financing. I interpret this to mean that we should not provide governments with permanent funding guarantees. This also protects us against fiscal dominance and allows us to continue making our decisions independently.
You are also head of the global Financial Stability Board FSB. Where do you currently see the greatest dangers in the global financial system?
The costs of servicing debt are of course rising significantly due to the rapid turnaround in interest rates. And there is then the risk that these costs cannot be borne by all debtors. I therefore expect insolvencies and corporate bankruptcies to rise – including among small and medium-sized companies and private households. Loan defaults, or NPLs, will certainly not remain at the very low level they have been at for a long time. But if this is an orderly and predictable process, without major shocks and abrupt adjustments, then I think the economy and the financial system will be able to cope relatively well.
Do banks need stricter regulation – even after the turbulence in March?
We should never be complacent. The most important thing is the full implementation of Basel III. The US banks that got into trouble were not covered by Basel III. Because of their failures, we should assess whether there are any lessons to be learned for our treatment of interest rate risk in the banking book and liquidity risk in the banking sector. The Credit Suisse takeover has also raised a number of questions about the cross-border applicability of bail-in measures. Outside the banking sector there is still the problem of hidden leverage emerging from time to time. As part of the FSB's work programme for non-bank financial institutions in 2024 we aim to do a more structural assessment of where these vulnerabilities are and what we can do about them.
The interview was conducted by Mark Schrörs.
