Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Marina Klepo on 29 September 2023
6 October 2023
Overall, the recent news on inflation is encouraging. Headline inflation in the euro area has declined notably, and it now stands at 4.3% after peaking at 10.6% in October of last year. A large part of the drop can be attributed to a reversal of previous shocks, as energy and food price inflation have fallen rapidly. It is also a consequence of statistical effects, the so-called base effects, given that we had unusually large price increases a year ago. When it comes to core inflation, which excludes energy and food, it has proven more stubborn and now stands at 4.5% in the euro area, hence above headline inflation. However, its September print was lower than expected. It is welcome that inflation is coming down swiftly, but it is still well above our target of 2%, which we should aim to reach by 2025 at the latest to keep inflation expectations firmly anchored. Given the persistence of underlying inflation, that “last kilometre” may well prove to be the hardest.
How worrying is the oil price increase that we have witnessed in recent months?
The recent rise in oil prices is telling us that we cannot take it for granted that inflation will only move downwards from now on, because we could have new supply side shocks stemming, for instance, from energy or food prices. This year, we’ve experienced frequent extreme weather events, which may have an impact on harvests and lead to higher food prices next year. In addition, the base effects from energy may eventually reverse, putting upside pressure on inflation. Therefore, we must not be complacent, and we should not declare victory over inflation prematurely.
What does it mean for the broad expectations among economists, the financial markets and even among central banks, that there will be no need for further interest rate hikes? That’s at least how the latest ECB messages have been interpreted.
One has to look carefully at what we communicated. We said that our decisions will continue to be data dependent. Our policy rates are now at restrictive levels and this will make a substantial contribution to a timely return of inflation to our target of 2%. However, we cannot say that we are at the peak or for how long rates will need to be kept at restrictive levels. This will depend on the data, so we will continue to look at three factors: the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. Currently, all of them are moving in the right direction. But I still see upside risks to inflation. There could be new supply side shocks. Moreover, wages could grow more strongly than expected, potentially accompanied by lower-than-expected productivity growth, while firms might not absorb those higher costs through their profit margins. Such risks need to be monitored carefully. If they materialised, further interest rate hikes could be necessary at some point.
Even though inflation has slowed considerably, there are still major differences in inflation rates among countries, ranging from negative numbers in the Netherlands to almost 9% in Slovakia. To what extent do these differences affect the setting of monetary policy? Are they really taken into account?
Our primary mandate is to maintain price stability in the euro area as a whole. Naturally, our monetary policy decisions also take into account information from individual Member States, but we cannot respond to specific developments in a particular country. Such developments are best tackled by national policies, such as fiscal or structural policies. The unusual heterogeneity of inflation rates is largely driven by differences in energy and food inflation. There are several reasons for the large role played by energy: First, countries that relied on Russian energy to a greater extent faced a stronger surge in energy inflation. Second, governments responded differently to the energy price shock, with some governments imposing price controls, which meant that they initially had lower inflation rates but may experience higher inflation later on. Of course, these measures also had different fiscal implications, because some of them expire automatically when energy prices fall, while others need to be actively reversed, which typically takes longer. And finally, the institutional characteristics of energy markets differ across Member States. In some of them, wholesale energy prices translate quickly into retail prices, both when energy prices rise and fall. In other countries the response is more sluggish due to the fact that there are fixed-price contracts in place with a long duration. One of the reasons why inflation in Croatia was so high was food prices, which constitute a large share of the consumption basket. This heterogeneity complicates our monetary policy, but we nevertheless need to focus on the euro area as a whole.
The government in Croatia, as well as in some other countries, is trying to introduce price controls on energy and certain basic consumer items. What is your view of these measures, what are the good and the bad sides of such an approach to lowering inflationary pressures?
Measures that directly control prices, such as price caps, have a dampening effect on inflation in the short run, which may be reversed once the measures are lifted. This helps to smooth inflation over time, but it also distorts the steering effect of prices. This may be counterproductive, because it does not incentivise lower consumption, for example, of energy. In addition, such measures can weigh heavily on the fiscal budget, especially if they are broad-based rather than targeting the more vulnerable groups. In general, measures that increase the supply capacity are preferable to those that directly control prices.
But do they work in the short run?
In the short run, they can have a positive effect in the sense that they lower current inflation, which may positively affect the inflation expectations of consumers, as these often depend on current developments in inflation. But overall, the negative effects often outweigh the positive.
One of the problems in Croatia, which has one of the highest inflation rates in the euro area, seems to lie in ample excess liquidity in the banking sector. This has increased strongly since Croatia joined the euro area on account of banks’ lower minimum reserve requirements. The argument is that this impedes the transmission of higher ECB interest rates and prevents a stronger impact on inflation. What do your analyses on the success of monetary policy transmission in Member States indicate?
What matters for monetary policy in a currency union is excess liquidity at the euro area level and not at the country level. Excess liquidity in the euro area is very high, but this does not impede monetary policy transmission. We have seen that the increases in our key policy rate, the deposit facility rate, have been fully transmitted to the money market and have translated into a measurable increase in funding costs in the economy. But you are right, monetary policy transmission can play out differently across Member States. One crucial factor is the prevalence of variable versus fixed-rate loans. The average lending rates adjust more quickly if there is a higher share of loans with a variable interest rate. Croatia is a special case, given that it joined the euro just recently. The drop in minimum reserve requirements from a level of 9% to 1% led to an increase in excess liquidity in the system. However, the strong loan growth that we are seeing in Croatia is not related to this but to the relatively strong economic performance, which is partly driven by the boom in tourism. That is why the Croatian National Bank decided to further increase the countercyclical capital buffer for banks to counter excessive loan growth. This is another way of dealing with the heterogeneity in a currency union, using macroprudential tools at the national level.
Would that be in the national central bank’s domain?
Yes, these macroprudential tools are mainly decided at national rather than European level – in Croatia’s case by the central bank – so they can be adjusted to the specific situation in a given country.
Do you see tourism as the main contributor to economic growth and credit activity in Croatia?
It is definitely one of the factors driving growth in Croatia’s economy. It has always been a very attractive place for summer holidays, and its attractiveness has probably increased since it joined the euro area. Two of my daughters, for example, travelled to Croatia recently, not only because it is beautiful, but also because it now has the euro.
The general public is concerned by the fact that banks are faring the best under the current circumstances, because they are generating high income from central banks without any effort or risk.
This is related to the high volume of excess liquidity created by our previous monetary policy actions: the lending operations and bond purchases, which we call quantitative easing. Excess liquidity is remunerated at our deposit facility rate, which currently stands at 4%. In line with our interest rate tightening, we have now started to shrink our balance sheet, and this is happening very quickly, even though the balance sheet is still very large. We need to pay interest on reserves, at least at the margin, to make sure that short-term money market rates are closely anchored to our policy rate and therefore in line with our intended monetary policy stance. Raising interest rates was necessary to bring inflation back under control. Now, what seems to create most of the unease is that banks raised their lending rates much more quickly than they passed these increases on to their depositors. But this transmission is getting stronger. Rates on time deposits have risen quite a bit, and we also see that people are beginning to shift their funds out of sight deposits into alternative investments that pay higher interest rates. This market mechanism eventually forces banks to adjust their deposit rates. But this also means that banks’ funding costs will go up over time. Even though the impact on profitability is very positive in the short run, longer-term consequences of higher interest rates on bank profitability may well prove to be less benign, because the interest income on bank assets may rise more slowly than their funding costs.
The ECB recently abolished the remuneration paid to banks on minimum reserves, but there are proposals for an increase in the minimum reserve requirement ratio at euro area level to reduce liquidity in the system. What is your view on this?
In July, we had a comprehensive discussion on the minimum reserve requirements and their remuneration. We came to the conclusion that, from a monetary policy perspective, it would be appropriate to keep them at a level of 1% but to remunerate them at 0% instead of applying the deposit facility rate, which currently stands at 4%. Let me stress three points. First, our main tool for adjusting our monetary stance is our policy rates and not minimum reserve requirements. Second, minimum reserve requirements are linked to the volume of deposits, which means that they mainly affect banks with high holdings of deposits rather than those with high holdings of excess liquidity. Therefore, they tend to put a larger burden on smaller banks. Also, these higher reserve requirements may lead to “avoidance strategies” by banks, which could remunerate deposits by even less or shift them to entities outside the euro area, where there are no minimum reserve requirements. Lastly, we are currently discussing the design of our future operational framework for monetary policy implementation. As long as we do not know the role that minimum reserve requirements will play in this new framework, we should be cautious about making any far-reaching decisions. In any case, the reduction of excess liquidity through the shrinking of our balance sheet will continue for some time and, eventually, all our asset purchase programmes will go into full run-off.
Economic growth prospects have worsened quite substantially, with the possibility of recession not being excluded from forecasts. What is your understanding of the drivers and the consequences of this recent deterioration in the business climate?
Over recent months, we have seen that most economic indicators point to a slowing growth momentum. We first saw a pronounced weakness in the manufacturing sector, which started to spread to the services sector as the reopening effects from the pandemic faded. The Purchasing Managers’ Indices (PMIs) for manufacturing are in deeply contractionary territory, and those for services are also signalling contraction. Consumer confidence has increased notably over the past year but remains at low levels. All this is pointing to subdued economic developments over the rest of this year. While a technical recession cannot be excluded, there are no indications of a deep or prolonged downturn. One reason is the labour market, which is still quite resilient, resulting in strong nominal wage growth. As inflation falls, real incomes are rising, which supports economic growth going forward. What is clear is that our monetary policy will continue to have a dampening effect on economic growth.
So, there is no reason for concern of a deeper recession setting in?
We see indications of a period of stagnation but not of a deep or prolonged recession.
Still, the state of the economy in Germany, as a country that is a very important export market for many EU Member States, is not encouraging. How justified are the claims that Germany is currently the “sick man of Europe”?
Germany is facing both cyclical and structural challenges. Its economy has been hit twice: by the energy price shock and by weaker growth in China. This has exposed structural weaknesses linked to the dependence on cheap energy and on a booming economy in China that was eager to buy German manufacturing products. On top of this, Germany faces challenges regarding demographic developments, as it has a rapidly ageing society implying an increasing scarcity of labour, as well as the green transition which, as in many other countries, is facing political obstacles. Cyclical factors, i.e. weak domestic and foreign demand, will eventually fade, but the structural factors may weigh on potential growth and hence have longer-term effects. All this implies that Germany, as is the case with many other countries, will need to adjust its business model to the changing global conditions, as well as to its domestic challenges.
How likely do you think that is?
Germany has managed to transform itself in the past and I am confident that it will be able to do so today. Naturally, this requires strategic thinking and openness to change. In particular, the green transition offers Germany vast opportunities to regain its technological leadership. The economy will pick up eventually, but the main issue concerns long-term potential growth, and that depends very much on how Germany tackles its structural challenges.
Arguments that the global economy is generally entering a phase of weak growth and disinflation are gaining ground. What do you see as having the most impact on inflation looking ahead?
What we see in the euro area is that domestic price pressures have gained importance over time and they are now the main driver of core inflation dynamics. When input costs rose sharply, many firms raised their prices in excess of the cost increase. So we saw an increase in profits in many sectors, also due to temporary supply-demand imbalances caused by bottlenecks and reopening effects. As a result of rising prices, employees experienced a drop in real wages. Now employees are trying to regain lost purchasing power, and tight labour market conditions are making it easier for the unions to negotiate higher wage increases. It is through such second-round effects that inflation becomes more persistent. The weakening of the economy, which is partly due to monetary policy transmission, makes it harder for firms to pass through higher wage costs to prices, meaning they may need to absorb higher costs through their profit margins. We see indications that this is happening. How this will play out over time will be one factor determining how persistent inflation, particularly underlying inflation, will be going forward.
There is a major difference of opinion as to how corporate profit margins over the last period have spurred inflation growth, with some analyses pointing to the conclusion that they were totally irrelevant.
Inflation is not only the result of rising wages or higher energy prices. Profits have also increased quite a lot over recent years. Looking ahead, the question is by how much wages will increase and to what extent rising wage costs will be absorbed by profit margins. It is only natural to expect that the unions and employees will try to regain some of the lost purchasing power and that wages will grow. But it is crucial how firms respond, and that depends on demand conditions and hence on our monetary policy.
Fiscal policy is expected to be prudent and cautious in order to curb inflation. However, politicians have their own concerns, such as a decline in the living standards of their citizens and in investment. On account of its widening fiscal deficit, Italy is again in the spotlight, and so is an increase in its bond yields. How does one reconcile these opposing goals?
We have long argued that governments need to promptly roll back their support measures from previous years, which were often not targeted enough and have risked fuelling inflationary pressures. However, we have also learnt over the years that consolidation should not come at the expense of necessary public investments. What really matters is the composition of public spending, which should aim to make the economy more productive and to strengthen the supply capacity. This in turn benefits fiscal sustainability and is also having a disinflationary impact over the medium to long term. Therefore, it would be unwise to postpone public investments and structural reforms that are necessary to transform the economy. This is where the European funds come into play. The Next Generation EU programme can help countries to continue investing in their future. At the same time, the perception that the government can counter every economic shock through fiscal transfers is dangerous and could lead to unsustainable fiscal dynamics.
The ECB’s position that the price of borrowing will remain high for as long as necessary to reach the target inflation rate has been communicated quite clearly. Nevertheless, is there anything else that can be said in that context?
