Börsen-Zeitung, 17.6.2022

The ECB Governing Council wants to raise the key interest rate in July for the first time in eleven years, and it has also announced interest rate increases, some of them substantial, for the period thereafter – quite a turnaround from the rather cautious course of the past months. Did the latest decision surprise you?

What surprised me, and also markets, was the more hawkish tone compared to very recent communication. To some extent this was appropriate given the intensity and the broadening of inflationary pressures. But in my opinion the Governing Council is underestimating the downside risks to growth. Saying that “growth remains solid” in such highly uncertain environment when disposable income has taken a big hit  seems strange to me. The odds of a recession has increased significantly.

After a rate hike of 25 basis points in July, it could be 50 points or even more in September. Is that appropriate in view of record inflation or too aggressive in view of the dangers of recession?

The ECB is increasingly operating in a very uncomfortable environment of stagflationary pressures: downside risks to growth and persisting inflationary pressures. It had to act, but the calibration of the measures is quite delicate. Fact is that we have seen a significant tightening of financial conditions, difficult to conciliate with previous communication on gradualism in monetary policy normalization. What is missing is a clear explanation of how the anticipated path of interest rates is going to bring inflation under control. Inflation is the result of demand and supply imbalances. Supply has been hit by a succession of shocks for which monetary policy has little influence. Aggregate demand is already under pressure with a fall in real income and much weaker consumer confidence. The recent tightening of financial conditions will further hit  aggregate demand. I think that this should lead policy-makers to be cautious.  The prevailing view however appears to be more hawkish but it stops short of communicating to the public that, according to their view, to bring inflation under control further compression of aggregate demand will be needed and that it will not be painless. This being said, I fully recognize that it is a difficult balancing act.

Where do you currently see the neutral interest rate in the euro area? Will it be enough to raise the key interest rate to this level or do we need a restrictive monetary policy to break the inflation momentum?

I never considered  that the concept of neutral rate was very useful in operational terms. There is too much uncertainty on its level . Monetary policy is transmitted to the economy via financing conditions which themselves affect aggregate demand and finally inflation. Changes in interest rates are only one aspect that determines the policy stance. What counts is the whole set of signals that the central bank communicates which finally affects financing conditions. In the present case, the ECB communication has led to a significant tightening of financing conditions in the Euro Area. The Governing Council will have to assess in the coming months to what extent this is appropriate or not on the basis of incoming information. So it is a kind of iterative process by which the central bank learns from the impact of its decisions.

The ECB announcements have triggered a sell-off in euro area bonds. Many observers are already warning of a new euro debt crisis. How great do you think this danger is?

A tightening of monetary policy unavoidably affects credit conditions more in countries with weak fundamentals, in particular weak public finances. The ECB has to take this into account in the calibration of its policy to the extent that financing conditions for the EA as a whole are affected. The change of direction of policy we are witnessing is radical compared to the past decade. Clearly, the end of asset purchases at a time of great uncertainty has led to strong market reactions,  producing a more than proportional tightening of financing conditions in an important part of the union. Although I wouldn’t yet qualify the market reactions as “disorderly”, they are certainly a warning shot.

Today the ECB’s Governing Council has met for an ad-hoc meeting to discuss the market situation and it has reaffirmed its commitment to use the PEPP reinvestments to preserve the functioning of the monetary policy transmission mechanism and it has intensified the work on a new anti-fragmentation instrument. Do we need a new ECB instrument to prevent risk spreads between euro government bonds that are perceived as excessive in an emergency?

What we first of all need is to further strengthen the euro area institutional architecture. This means more private sector risk sharing via the capital market union and the banking union, greater euro area fiscal capacity with well defined conditions, in the spirit of the NGEU. The ECB cannot become the backstop to the institutional weaknesses of the EA. Notwithstanding, in todays context of radical change in the monetary policy stance the ECB has to ensure that the process will be orderly. A successful  normalization of monetary policy should not give rise to non linear destabilising dynamics which could lead the ECB to backtrack. At the same time, the ECB cannot intervene in all circumstances. Designing new tools of interventions is not too complicated per se, but the difficult issue is how to specify the conditions under which such tool would be activated. Some degree of ambiguity is unavoidable but it is important in this respect that the GC speaks with one voice and shows determination to address the issue and, to quote I Schnabel, “that investors have a clear understanding that monetary policy can and should respond to a disorderly repricing of risk premia that impairs the transmission of monetary policy and poses a threat to price stability”. I think that an agreement on general guidlines on when and how to deal with fragmentation would be useful

Many ECB central bankers talk unusually openly about the weakness of the euro as an inflation problem – because it leads to rising import prices. What role should that play for the ECB?

Personally I have always been careful about communication on exchange rates. The weak euro vis-á-vis the dollar is certainly a factor to take into consideration in monetary policy-making, but it is only one factor among others. What we are seeing on foreign exchange markets broadly reflects the fundamentals. In the coming months we will have a clearer view on the evolution of the US economy. My impression is that a soft landing will be quite unlikely.

The ECB has colossally underestimated the inflation dynamic. What role did the new strategy with a greater tolerance for inflation rates above 2% play? What lessons must the ECB learn from this?

It is not only the ECB…and we may be wrong again for the future inflation outlook ! I still believe that the European situation is quite different from the US where the inflation surge has more to do with excess demand. The US the strategy review led to the “Flexible average inflation targeting”-policy which recommends some overshooting of inflation for some time in some circumstances. It may have played a role in the delayed reaction of the Fed to inflation pressures. The ECB was more prudent in not endorsing as such this concept. Overall I remain very positive on the outcome of the ECB strategy review. A number of issues have been tackled, like including  financial stability considerations in the monetary policy deliberation.  

The interview was conducted by Mark Schrörs.