Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Gerald Braunberger and Christian Siedenbiedel on 16 December 2022
24 December 2022
Ms Schnabel, among other things, 2022 is likely to go down in history as the year of high inflation. As one of the ECB’s Executive Board members responsible for monetary policy, does this trouble you?
I have been working intensely on how to tackle high inflation all year. The ECB’s mandate is to maintain price stability. With inflation at times exceeding 10%, we can hardly speak of price stability. That is why we are doing whatever is necessary to bring inflation back to our medium-term target of 2%.
Do you yourself feel the effects of the extremely high inflation in your daily life?
Sure, one notices that everywhere – when shopping, visiting a restaurant or paying the gas bill. But people on lower incomes are bound to feel those effects far more keenly; in many cases they have no savings to draw down and they are especially hard hit by the high prices for energy and food.
When did you first have the impression that serious inflation lay ahead?
I noticed some warning signs early on. In a speech that I gave in July 2021, I presented a series of indicators pointing towards a rise in inflation. However, I did not go all the way in drawing the right conclusions. For a long time, we believed that many of the causes of inflation would vanish over time. Put simply, the 10% inflation that we observe today can be divided into two parts: the first 5% emerged in the year 2021 and the second in 2022. Inflation in 2021 had to do with the after-effects of the pandemic. After the economy reopened, demand rapidly took off and met a relatively inelastic supply, exacerbated by supply chain disruptions. This imbalance of supply and demand triggered the first surge in prices.
Though couldn’t we have expected a certain surge in prices after COVID-19?
Indeed, but many people underestimated the extent of it; they thought that the supply chain disruptions would be resolved more quickly. But that took much longer than expected. Inflation had already reached 5% at the end of 2021.
But it didn’t stop there…
Russia’s terrible war of aggression against Ukraine this year made matters worse by causing another price surge, particularly through rising energy and food prices. It was especially concerning that these price increases gradually broadened across the entire basket of goods. Not only energy prices rose steeply, but also core inflation, that is inflation stripped of the volatile prices for energy and food. By that time, it was clear to everyone that inflation would be more persistent.
You have an academic background, you were a professor on the German Council of Economic Experts. What is it like finding yourself in a situation for which no appropriate model seems to be available − at least not one that can be found offhand? That’s not a particularly comfortable place to be in as an economist, is it?
Models are available, but they are difficult to apply in practice. The challenge is to identify the causes of inflation, and the correct response, in real time. An important distinction is whether the shocks are driven by supply or demand. Monetary policy can deal effectively with demand-driven shocks. Higher interest rates temper demand and counter overheating. Unlike in the United States, however, the disruptions in the euro area were predominantly on the supply side. That makes it harder for monetary policy, as it cannot directly remove the causes for the price increase. If we knew that supply chain disruptions and the strong surge in energy prices would disappear quickly and that the high inflation would not spark any second-round effects, monetary policy would not have to react at all to such supply-side shocks because it would only take effect when the shock has already abated. But we are now seeing a whole series of such shocks, which raises the risk of second-round effects. At the same time, the robust labour market, fiscal policy and the savings accumulated during the pandemic are supporting demand.
Did the ECB make any mistakes during this process?
We underestimated the persistence of inflation and initially did not take the signs of higher inflation seriously enough – not least because we were coming out of a phase in which the main risk had been that of too low inflation. But let’s not forget that there was great uncertainty owing to the recurrent waves of the pandemic. There was a concern that premature action by monetary policy might unnecessarily push the economy into another recession.
The ECB has now raised interest rates four times. Will further interest rate increases now be more difficult to push through politically – especially if the inflation rate dips down in some months?
Since July, we have increased interest rates significantly at every meeting of the ECB Governing Council, often by more than expected. For some time, financial markets assumed that, at the first sign of a trend reversal of inflation, the ECB would stop raising rates forcefully. That is why our latest monetary policy decision was so important. ECB President Christine Lagarde stated unequivocally that we would continue raising interest rates for as long as necessary to bring inflation back to our medium-term target of 2%. Financial markets reacted to this immediately. The terminal rate, which is the peak rate expected during the interest rate cycle, has risen above 3%. Whether we will still need to go higher than that will depend on the future inflation outlook.
Will interest rate hikes become trickier if the euro area enters a recession and if the US Federal Reserve stops raising interest rates at some point?
Interest rate hikes are rarely popular, as households, firms and governments are confronted with rising financing costs. At the same time, higher interest rates dampen economic activity. So we have to explain why what is initially perceived as harmful will provide stability and foster investment and growth in the longer term.
But we are now entering a phase in which it will be more difficult to reach any kind of unanimous agreement on how these different influences should be assessed. People may have good reasons for holding differing opinions. Wasn’t that why the ECB Governing Council found a compromise at its December meeting and only raised interest rates by 0.5 percentage points while at the same time announcing a path of further interest rate hikes?
The aim was to clarify that the terminal rate may be higher than many market participants expected. How exactly that rate is achieved is then of lesser importance. What mattered is that we agreed that further interest rate hikes are necessary. ECB President Christine Lagarde is a master in achieving consensus. But that will certainly not get any easier in the future.
Italy has strongly criticised the most recent rate hikes. Do you suppose that the question of how to proceed will lead to more conflicts from this side in the future?
Governments generally don’t like interest rate hikes very much. They weigh on the fiscal position as it becomes more expensive for states to issue new debt. So we can expect increasing pushback and we need to withstand it. That’s exactly why central banks are independent.
Is there any scientific basis that indicates how much the ECB has to raise interest rates in order to fight inflation successfully?
All models are subject to considerable uncertainty. There are also factors that we cannot possibly predict. When will the war end? What will happen next with China’s reopening?
Former ECB Chief Economist Peter Praet has said that calculating a natural or neutral interest rate that neither subdues nor boosts economic activity does not make any sense for the eurozone, as the eurozone is far too heterogeneous. At the same time, the ECB has created the impression in the last few months that such a thing does exist. On further enquiry, we learned that it is actually more of a communication tool. Can you really sell that to anybody?
Estimates of the neutral interest rate are subject to considerable uncertainty. The neutral interest rate is therefore more of a conceptional framework than a tool that helps our actual decision-making. In any case, we clearly have to reach an interest rate that is high enough to bring inflation back down to 2%. According to our assessment, this interest rate lies in restrictive territory – that is, above the neutral interest rate – even if the exact level is yet unknown. This means that the inflation problem will not go away on its own.
Do you think that the ECB can overdo the interest rate increases?
Monetary policy works with a lag, meaning that most of its effects are observed only with a delay. The exchange rate reacts relatively swiftly – we are feeling the effects of this already. Inflation expectations, which influence wage negotiations and price setting, can also adapt rather quickly. However, the standard monetary policy transmission mechanism through the banking sector takes longer – around one to two years. We could end up overreacting if we were to only focus on the current rate of inflation. That is why we need models that give us an indication – in spite of all the uncertainty – as to how our interest rate increases affect the economy and inflation over the medium term. At the moment, however, the danger of overreacting continues to be limited, as real interest rates are still very low.
So do you still trust these longer term projections? Do you actually anticipate that inflation in 2025 will be 2.3%, as per your official stance?
The uncertainty for 2025 is high and we know that the models tend to project that inflation eventually returns towards 2%. This is due to the assumption of a credible central bank. Still, in our projections inflation remains notably above 2% over an extended period. As inflation expectations are strongly dependent on what people are actually experiencing, this can affect wage and price setting. A long phase of very high inflation – as we are currently seeing – is therefore problematic. It makes it all the more important for us to react decisively.
At its last meeting, the ECB Governing Council also decided to test reducing the asset purchase programme (APP) holdings from March, initially for four months. Why is the ECB being so cautious, and what risks do you anticipate?
Our primary monetary policy instrument in the current situation is the interest rate. It is the tool with which we want to reduce inflation. At the same time, such a large ECB balance sheet is evidently incompatible with the current inflation outlook. We need to reduce it gradually, ideally in a predictable way, quietly in the background. With such a measured approach, we want to avoid disruptions in the bond markets.
You recently experienced a more significant impact on your balance sheet owing to the repayment of the targeted longer-term refinancing operations (TLTROs). To what extent can such steps be taken to reduce the likelihood of losses for central banks?
The TLTROs were granted at very low interest rates, at a time when no one expected interest rates to increase so soon and so strongly. When we started raising interest rates rapidly, it affected banks’ interest rates in a way that ran contrary to our monetary policy goals. The banks no longer had an interest in repaying the loans early and would have kept them until they matured. This made it necessary to change the conditions. So there was a clear monetary policy case behind it, even if it has side effects on the central banks’ profit and loss accounts. The same goes for the reduction in bond holdings.
Many governments are also currently trying to soften the effects of inflation. Are the fiscal measures taken by the euro area countries helpful in tackling inflation?
Governments need to protect the most vulnerable parts of society. However, the steps taken should be targeted and should not mute the price signals. Germany’s gas bill cap is a good example of how to maintain proper incentives. In addition, investments and structural reforms are necessary for fighting the root causes of inflation. Speeding up the green transition would make us less dependent on fossil fuels in the medium term. In reality, only a regrettably small share of the government measures in the euro area were targeted. The measures rarely maintained proper incentives, and there were next to no additional investments in the green transition. That is why many of these measures actually tend to fuel inflation in the medium term.
In June the ECB convened a special meeting as yields in Italy surged, but no special meeting has been called as a result of the surge in inflation. In the process of normalising monetary policy, did the ECB have to give extra consideration to countries that are heavily in debt?
We are in an extraordinary situation in which major central banks across the world are rapidly raising interest rates. Rising interest rates typically also lead to increases in risk premia. This is a normal process, which poses no problems as long as it plays out in an orderly manner. However, we know that disruptions in the bond market are more likely during such phases, and that we can only consistently pursue our path of interest rate hikes if we can at the same time make sure that there will be no disturbances in the bond market. That is why we are applying flexibility in reinvesting redemptions coming due in the pandemic emergency purchase programme (PEPP). Furthermore, we have established the transmission protection instrument (TPI) in order to ensure the smooth transmission of monetary policy across all euro area countries and to prevent a sudden surge in bond yields that is not justified by fundamental factors. It is this combination of measures that made our large interest rate steps feasible.
Since October the ECB has been taking climate criteria into account when reinvesting funds from its corporate bond purchases. How have these initial encounters with green monetary policy been?
I would not call it “green monetary policy”. That makes it sound as if the primary goal of our monetary policy is climate protection. We have in fact discovered that our corporate bond portfolio contains a significant bias towards energy-intensive firms. In order to counteract this, we now take into account climate criteria when reinvesting funds from maturing bonds. We determine a climate score for firms whose bonds we buy. This reflects the firms’ emissions, their plans for lowering them and their transparency regarding climate risks. Therefore, we are partly buying different bonds than before, but this does not yet have a major effect on the portfolio as a whole. We cannot substitute for the climate policy of governments. But we can and we must – within our mandate – align our monetary policy with the EU’s climate objectives and thereby be a role model in financial markets.
