Interview with Luis de Guindos, Vice-President of the ECB, conducted by Martin Arnold
2 October 2023
It’s been two weeks since the ECB raised rates for the tenth consecutive time, have you now done enough to tame inflation?
Let me stress an issue, which is sometimes slightly overlooked but is a very important part of the discussion, namely the transmission of monetary policy. That’s crucial in order to understand the decisions that we have taken and those that we will take. In transmission you have two different legs. The first one is from our monetary policy decisions to financial markets and banks. In that first stage, the transmission is almost complete. You can see it. In the banking channel, there has been a tightening of financing conditions following our decisions. And there has been a significant drop in the demand for credit.
The second phase is how the impact of the tightening of financing conditions feeds through to the real economy. And here there is much more uncertainty. We have seen a slowdown in economic activity. But there are other factors behind that, for instance the impact of inflation on households’ disposable income and the evolution of exports, which is related to the slowdown in the global economy. The key point that will determine our future decisions is how intense the transmission of our monetary policy will be to the real economy, and indirectly to inflation. That is why we believe that the present level of interest rates, if maintained over time, will give rise to a reduction in inflation towards our definition of price stability.
Do you worry about the risks of overdoing the tightening of monetary policy and driving the economy into an unnecessarily painful recession?
We do not at all want to create an unnecessarily painful recession. We must bring inflation to our definition of price stability while simultaneously trying to minimise the pain that could create in terms of a slowdown in the economy. This is, at the end of the day, a very delicate balance. If the transmission is incomplete, then we should be a little more patient. If the transmission is much closer to completion, then we should consider the next steps to guarantee that inflation converges to our target.
Does the recent rise in oil and gas prices, coupled with a weaker euro, make your task more difficult?
Yes, it makes our task more difficult. I would not say that it is a game changer. But my concern is that the rise in the oil price could have a detrimental impact on inflation expectations for households and corporates.
What would it take for the ECB to start cutting rates?
Well, we are not there.
But what would you need to see?
First of all, progress in a very steady way towards our definition of price stability, i.e. to inflation of 2 per cent along with projections indicating it will remain at that level in a sustainable way. Starting to talk about rate cuts now is premature. We have reduced inflation from more than 10 per cent to 4.3 per cent. Still, I think the last stretch is going to be more difficult. We are on our way towards 2 per cent. That’s clear. But we must monitor that very closely, as the last mile will not be easy.
But would the last mile be the hardest to achieve in bringing inflation down?
First let’s look at the factors in favour of disinflation. Base effects have an impact. Supply side bottlenecks have started to fade away. And there is monetary policy and the clear slowdown in the economy. In the second half of the year the economy in the euro area will have stagnated.
Now let’s turn to factors against disinflation. There’s a spike in oil prices. Wages are growing about 5 per cent on average. Demand for services is high, even though we have started to see a clear slowdown. And the euro has depreciated.
So, when you put all this in the balance, our predictions indicate that inflation will continue slowing down over the next months. But we need to monitor it very closely because the elements that might torpedo the disinflation process are powerful.
Are governments making inflation worse by continuing to run big deficits?
The first factor with respect to fiscal policy is the withdrawal of the subsidies granted over the last two years, which must be completed before the end of 2023. But it’s not only that. There is also the fiscal stance, which sometimes gets overlooked. My impression is that after four years without EU fiscal rules, governments may have got used to a little bit of a “whatever it takes” approach with respect to fiscal policy. But that has to change. Having a tightening of monetary policy and, simultaneously, an expansionary fiscal policy would be a very bad policy mix. And being more concrete, what would be detrimental is a fiscal deficit that goes above the level of 2022.
Does the ECB need to reduce the amount of excess liquidity in the banking system?
We are doing that. And this is totally normal in the process of normalisation of monetary policy. That is the correct pace, the correct path. TLTRO reached €2.1 trillion and now we are a little bit below €500 billion. And over the next year it will become close to zero.
What about stopping reinvestments in the Pandemic Emergency Purchase Programme?
Some of my colleagues in the Governing Council have been quite outspoken with respect to the need for starting the process of quantitative tightening on the PEPP. But in the formal structure of the Council, we have not even started the discussion. It will arrive sooner or later.
Do you still need the flexibility of PEPP reinvestments as the first line of defence against financial market fragmentation, despite not having used it for two years?
If you ask the military, they will tell you that extra lines of defence are always good. Yes, we could use flexibility in the reimbursement of the PEPP to address fragmentation. It has not been used for two years because spreads are quiet. The PEPP is less than €2 trillion. Therefore, even doing a full run-off, the withdrawal of liquidity will not be huge. It is the first line of defence in times of volatility in markets, but that is not the case now. So, we’ll have to analyse it.
How about the banking system? Do you expect an increase in non-performing loans?
Return on European banks’ equity has clearly improved because of the widening of net interest margins after the increase in interest rates and it is now above 10%. Two years ago, it was around 4%. But banks’ valuations have not moved in parallel. Why? I think that the main reason is because the cost of equity of the European banks has increased quite a lot and it’s close to 15%. When interest rates increase, the cost of equity also goes up. Markets are also pricing in that the improvement in profitability will not be sustainable over time because they are factoring in an economic slowdown. And they price in that banks will have to increase provisions should non-performing loans levels go up.
This means profitability will be dented in the future. The current figures are a sort of illusion. In the pipeline, we start to see that the quality of the assets is deteriorating, and there’s an increase in non-performing loans. On top of that, taxes on bank profits have created some uncertainty.
Should countries not introduce bank taxes?
Not all bank taxes are identical. You have seen that in the case of Italy. The final proposal is much more sensible than the first one. Our point is very clear: these taxes should not impair credit and should not create any limitation in the capitalisation of European banks. This applies as well in terms of the banks being prudent in dividend payments and share buybacks, and even the remuneration of bankers.
Some members of the Governing Council would like to increase the minimum reserve requirements for the banks, on which you pay no interest. What do you think of that?
My opinion is that we should conduct monetary policy based on price stability, not on the profit and loss of national central banks. To reach price stability, you have to reduce liquidity. The reduction of liquidity will give rise to a reduction of these windfall profits that the commercial banks are getting at the moment because of increasing interest rates.
Are there any signs of distress in the property sector?
In commercial property there has been a very important decline in prices, mainly in some Nordic countries. The main problems have appeared in Sweden, Finland, the Nordic countries. But it’s quite pervasive. Residential real estate is more resilient. But, for instance, in the case of Germany, it was not a total surprise to see the recent data showing that house prices have declined by almost 10%. That’s a clear indication that there were some pockets of overvaluation that are going to be corrected. Our concern now are the non-banks, the property and mutual funds, that have a big exposure to real estate. I would say that commercial property – even though we also need to pay attention to residential property – is our main source of concern in terms of financial stability.
