Interview with Luis de Guindos, Vice-President of the ECB, conducted by María Jesús Pérez, John Müller and Daniel Caballero
25 June 2023
The ECB’s greatest concern, its greatest challenge, is inflation. What can be done to overcome this crisis?
Last week we published our growth and inflation projections. Moderate growth is expected of below 1% this year and around 1.5% the next two years, with risks tilted to the downside. Monetary policy measures are starting to have an impact on financing conditions. The contraction in credit will pass through to the real economy. In turn, dampening demand will lower inflation. Our projections show that headline inflation in the euro area is clearly declining. We expect it to average 5.4% this year, 3% next year and to be slightly above 2% in 2025. However, underlying inflation (stripping out energy and food) is projected to reach more than 5% this year, mainly driven by unit labour costs. The labour market is robust and, although wage growth is in line with our projections, productivity is slowing, resulting in an increase in unit labour costs. This is essentially what explains our higher underlying inflation projection. In the medium term, headline and underlying inflation will no doubt decline, but we haven’t yet reached our price stability target.
Is that target still a long way off?
The latest series of interest rate hikes has been the steepest since the euro was introduced, and its effects are beginning to pass through to financing conditions, with a significant decline in the demand for credit affecting real economic activity. If this slows down, so will inflation. The finishing line is in sight.
Can we expect an end to interest rate hikes before the summer holidays?
That will depend on the data. So far, we have raised rates by 400 basis points and can already see the impact this is having, but we need to ensure that inflation converges and holds at around 2%, our price stability target. What happens with underlying inflation is paramount.
How can underlying inflation be tamed? It seems difficult to control.
The monetary policy measures we have already adopted will help, as will the base effects. Prices are not going to rise as sharply this year as they did last year in response to the shock triggered by Russia’s invasion of Ukraine. It is essential that we monitor second-round effects, rising wages and the behaviour of unit labour costs. If the situation deteriorates, monetary policy will have to act more forcefully. Fiscal policy must also play a part if we are to reduce inflation.
Spain always lagged behind the European Union when it came to inflation. And now the Spanish prime minister is boasting that we have one of the lowest rates in the euro area. Why is that?
Because of several factors related to energy, base effects and fiscal measures. But Spain’s underlying inflation is now in line with the euro area.
There are structural forces at play here.
One could even say that Spain provides a leading indicator for future inflation in the euro area. Inflation in Spain initially rose at a faster pace than in the euro area, but has subsequently slowed more sharply, whereas underlying inflation has proved to be much stickier than the euro area average.
Are these asymmetries between European countries easy to identify from your position at the ECB?
There have always been differences, but they are arguably more marked now. Proximity to war has a lot to do with this. Inflation is higher in the Baltic states. The current inflation scenario cannot be understood without taking into account the wave of shocks that have hit Europe: the pandemic, the reopening of the economy and Russia’s invasion of Ukraine. Without the expansionary monetary and fiscal policies of 2020 and 2021, the fall in GDP would have been far more pronounced. In such exceptional circumstances, we must adhere to the lesser evil principle. There is no one perfect measure to cover every economic parameter, so one has to choose the least harmful.
Is the lesser evil now a possible recession in the euro area?
The priority now is to bring down inflation, because of its very negative impact on social well-being. Inflation is an economic evil. Fighting it must be our goal.
Does inflation come before growth?
It is very difficult for economic growth and stability to co-exist with high inflation. The possibility of combining high inflation with high growth vanished with the series of supply shocks that we have seen. If we are to resume strong growth, inflation must come down.
The European Commission has asked Member States to roll back the support measures they adopted in response to the energy crisis. Is this a way to stop fuelling inflation?
Energy prices are lower than they were when the war started. The support measures adopted to shield the most vulnerable sectors made sense at the time, but they now need to be gradually rolled back. This will help correct the public deficit. Countervailing fiscal and monetary policies, i.e. one that is expansionary, the other restrictive, should be avoided. If that were the case, inflation would not drop as expected and a stronger monetary policy response would be called for. Instead of having the finishing line in sight, a tighter monetary policy stance would be needed.
Some European countries are concerned about their deficit, which you have just mentioned. You stated that it would be reduced, before or after the pandemic, and that countries with higher deficits and debt levels would have to implement adjustment programmes. Do you still see that as feasible?
The gradual return to some degree of fiscal discipline that ensures the long-term sustainability of public finances is currently a subject of debate across the EU. We cannot continue with the fiscal policy of the last four years. That is true for all Member States, particularly those that are more vulnerable from a fiscal standpoint.
Some economists in Spain say that the Spanish economy has been stagnating since 2006-2007. According to the Banco de España, we are no longer converging with other European economies. Should we be concerned?
Two factors explain the divergence of Spain’s per capita income with respect to the euro area average: the severity of the 2008-2013 crisis and the pandemic. Spain has practically returned to pre-pandemic income levels, but this is not yet the case for per capita income. Some recovery was seen from 2013 to 2019 and I hope that convergence with the euro area will continue in terms of per capita income. For this to happen, we must ensure fiscal sustainability. The Spanish financial sector is not giving any cause for concern and the country has posted a current account surplus for the last ten years. However, there is room for improvement. Spain needs a fiscal sustainability plan, it must ensure domestic market unity, address the aspects of the labour market that are not working and undertake educational reform to address the supply-demand imbalance. All these reforms are structural and require political consensus and government policies. Many can only be achieved if there is agreement between the main political parties.
Are you optimistic an agreement will be reached?
The funds made available through the Next Generation EU programme provide us with a great opportunity to invest in digitalisation and the green transition. However, bringing about a reduction in the deficit will require changes to how autonomous regions and local governments are funded, as well as tax reform. It will be very difficult to achieve this without an agreement between the main political parties.
Would you agree that we are lagging seriously behind when it comes to implementing structural reforms?
That is clearly the reason behind the Spanish economy’s sluggish recovery.
From your position at the ECB in Frankfurt, you can clearly see all of these differences and disparities in growth. Do you feel that a European fiscal union is what is missing?
I have always been in favour of more centralised fiscal policy. Having a more centralised fiscal policy, a common budgetary instrument, makes even more sense when there is a crisis.
There are also differences in the euro’s depreciation, for example, between Spain and Germany. Will we be hearing about the risk premium again?
The risk premium is primarily linked to fiscal policy. As far as the financial market turmoil in March is concerned, all indicators of this turmoil have recovered or improved since then. What’s more, two banks recently issued Additional Tier 1 bonds. European banks have higher levels of capital and more liquidity. But they shouldn’t get too ahead of themselves. Even though they have coped better than banks in other countries, this doesn’t mean that everything is done and dusted. Banks will see a reduction in their revenues. Loans will see weaker growth, their cost of carry will increase and banks will have to start paying higher interest on deposits. And all of this will occur as the economy slows. Last year the euro area grew by 3.5%, but the projection for this year is 0.9%. In addition, rising interest rates may result in an increase in non-performing loans (NPLs). Banks are benefiting from the increase in their net interest income following the rise in interest rates, but they have to look beyond this initial effect and not get carried away just yet.
Does the ECB feel confident about the euro area banking sector at present?
We will publish the results of our stress test results in July, which will provide us with a more detailed picture. The European banking sector has so far coped well with the impact of the problems certain medium-sized US banks and Credit Suisse encountered. However, our recently published Financial Stability Review highlighted some risks and vulnerabilities, including the drop in loans and the potential increase in default rates.
Would you go so far as to say the next crisis won’t be financial in nature?
In the euro area, there is currently very moderate growth, a services sector that is outperforming the manufacturing sector, a robust labour market, tighter financing conditions and a more solid banking system than ten years ago. Financial crises always start in the real economy owing to excessive indebtedness. This is not the situation at present. European households currently have relatively reasonable levels of debt, as do firms in general. But fiscal imbalances have grown. And with interest rates rising, vulnerabilities that built up during the period of low interest rates could bubble to the surface. That’s why we must be vigilant.
But there does seem to be a crisis of confidence in financial institutions.
There has been a reputational crisis, but not so much a crisis of confidence as I see it. On average, banks’ share prices have improved, for example, over the last few months.
To keep this spectre of mistrust at bay, would it be a good idea to create a common deposit insurance scheme?
Such as Germany’s?
I don’t want to mention specific countries’ positions. I would just like to stress that the lack of a European deposit insurance scheme could have negative consequences for the entire financial system.
The banking sector is in a better position than it was ten years ago, but in some countries, deposits don’t receive any interest.
In Spain, some people say there is tacit collusion among banks to not pay interest on deposits, and that there is a lack of competition owing to an excessive degree of concentration.
Competition has as much to do with the number of competitors as it does with their solvency. But the question of whether or not there is collusion is one for the competition authorities, not the ECB. There is currently still excess liquidity in the market, which means there is not as much need for banks to compete to attract deposits. But this excess liquidity is being withdrawn, which will result in banks having to start competing with each other.
Margarita Delgado, Deputy Governor of Banco de España, is among the front runners to become Chair of the Supervisory Board of the ECB. Would you support her appointment?
Do you have anything to say about Rodrigo Rato’s book?
I don’t get involved in discussions of this kind, and I wish him the very best. The bailout of the [Spanish] banking sector was conducted in a completely transparent way, and the Spanish financial system is in good shape today.
