Interview with Philip R. Lane, member of the Executive Board of the ECB, conducted by Marcel de Boer, Marijn Jongsma and Joost van Kuppeveld
16 October 2023
Why did it take the ECB so long to raise interest rates? The Federal Reserve started several months earlier.
First, in 2021 demand was playing a much bigger role in driving US inflation, so the role for monetary policy was immediate. Second, the ECB did not cut interest rates during the pandemic, as the Fed and BoE have done. So the first rate increases by other central banks were reversing the pandemic cuts. We did do a lot of QE (large-scale asset puchases, Ed.) and then the targeted lending. So our first job in December 2021 was to roll back QE and in July 2022 we raised rates for the first time. Now, would increasing rates a little earlier, say in March, have meant that inflation would have been visibly lower in 2022? I don’t think so. But the path to an interest rate of 4% would have been more gradual. But moving three months earlier is not something that materially would alter the trajectory of inflation. And there is a fairly good understanding that the source of the inflation was primarily the energy shock, as is also visible in our surveys of consumers. Our job as central bank is to make sure it comes back to target in a timely manner.
What should the ECB do if energy prices rise again – raise rates even higher and risk a deep recession?
This is definitely one reason why we hiked rates in September. When rates are restrictive then the ability of firms to pass on those energy price increases into consumer prices is less. History shows that when demand conditions are restricted, firms have to suffer lower profits rather than increase their prices. The current interest rate of 4% will also do a great deal to bring inflation back down, especially as there’s still more tightening in the pipeline. People with fixed-rate mortgages are not feeling the effects of the higher interest rate yet. And when interest rates on savings finally rise, banks will have to raise interest rates on loans further, too.
Trade unions see an opportunity to shift the balance between profit and wages. Could that lead to protracted second-round effects?
What I’ve been emphasising is that we are going to need to watch the labour market for quite a while. Collective wage agreements concluded in 2023 have to be seen in the context of a catch up from the high inflation last year. But to allow inflation to return to 2%, we need to see wage growth slow down in 2024. The unions know that the ability of firms to pay higher wages depends on the economic environment. And given the current, restrictive monetary policy we expect the economy to be pretty stagnant for the rest of this year and to grow modestly next year.
Germany is not doing particularly well, while other countries are faring somewhat better. How do you handle the differences within the eurozone? You can only pursue one policy.
We can basically only target the average. We’re seeing that inflation rates are quite different across Europe and growth rates are different. But let me stress that alongside the ECB policy, it’s necessary to have good policies at national level. National policies should be designed to fill the gap if the single interest rate does not suit every country.
QE is over, but there are still a lot of bonds on your balance sheet. Large-scale bond sales would send interest rates shooting up and some countries would be in trouble. Aren’t you a hostage to your own balance sheet?
We have stopped reinvesting the proceeds from maturing bonds in the APP. That means the balance sheet is shrinking every month. Under the PEPP bonds are being reinvested until the end of 2024. A few years ago many people worried about how the bond markets would cope when we ended QE. Now we know the answer: if the interest rate is high enough, many investors, European and global, are happy to lend to European governments. Compared with interest rates, the role of the balance sheet is of secondary importance. The most effective way to tighten policy further, if necessary, is to further increase the interest rate.
This will also keep the bond markets calm, since if investors no longer believed the ECB was tackling inflation effectively, they would demand higher interest rates. The worst scenario for European governments is if we fail to bring inflation back down to 2%, because then the interest rate on long-term bonds would be far higher than it is now.
Is 4% the peak policy rate, and when will it go down again?
Because inflation is too high, we’re trying to deliver interest rates that are significantly above the neutral range. We will keep interest rates high for as long as necessary. If we have inflation shocks that are sufficiently large or sufficiently persistent, we have to be open to doing more. We think inflation will return to 2% by 2025. Only when we are sufficiently confident of reaching that target, we can normalise policy. But this is quite some distance from where we are now. I personally will need more information about the wage settlements for 2024, and we will have to wait until spring next year before many countries release that information. So it’s going to be some time before we can have a high degree of confidence that inflation is on its way back to 2%.
So no lowering of interest rates until spring?
We are data-dependent. The world is full of uncertainty. There are risks on both sides, but we still see relatively high wage increases and there are still some parts of the economy where price increases are happening. So we cannot make a near-term call. We’re going to be on guard for an extended period.
And what will be the “neutral” level, which neither stimulates the economy nor holds it back?
Before the pandemic inflation was too low and we were trying to deliver interest rates far below neutral rates. Now inflation is too high and we are trying to deliver interest rates significantly above the neutral range. We do not think that inflation will revert to pre-pandemic levels. This is also reflected in studies and market prices, which indicate that once inflation is conquered, interest rates will probably return to around 2%. Maybe that is a reasonable guess about the kind of long-term average for policy rates. We won’t stay where we are now forever, but we also can’t envisage any scenario in which we go well below 2% without a major recession.
As the ECB’s chief economist, do you feel you have lost credibility by failing to see the inflation spike coming? Does that have implications within the Governing Council?
I think there are two issues behind your question. One is the natural question for people to ask, why did the economic profession in general, the central banking world, and indeed the Eurosystem and this includes me personally not fully anticipate what was happening. We made a whole range of calculations, but there was no scenario in which inflation suddenly surged as much as it did. So indeed, we did not see that coming. One lesson is that we have to be conscious that the world can change quickly. And that we need to express our humility in the face of uncertainty.
And for me in my role as chief economist: it is my personal duty to learn from these episodes, to make sure our analysis is as good as possible. And I would say that the Eurosystem staff have also learned a lot in the last years. Our most important task is to ensure that the analysis behind our policies is as good as possible, and secondly that our monetary policy brings inflation back down to 2% in a timely manner.
Many economists are saying that the hawks are now in the driver’s seat at the ECB. Is this a situation you recognise?
I believe this is not the way to think about how policy is made. And I think that’s probably a global situation. Inflation was so high that there was basically no discussion. This is not an episode where this kind of grouping across people is useful or necessary. It was obvious that inflation was too high and that a significant policy tightening was necessary. Press conference after press conference you could see that there was broad consensus or unanimity in the Governing Council.
