Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Balázs Korányi on 1 December 2023
5 December 2023
What is your take on the unexpectedly benign November inflation reading? Does the recent string of downside surprises change your view about the inflation trajectory?
“When the facts change, I change my mind. What do you do, sir?” I’m sure you know this famous quote that is often attributed to John Maynard Keynes.
Over the past year headline inflation has declined rapidly. This was due to the reversal of the previous supply side shocks and was mainly driven by energy and food prices. Base effects played a significant role.
The November flash release was a very pleasant surprise. Most importantly, underlying inflation, which has proven more stubborn, is now also falling more quickly than we had expected. This is quite remarkable. All in all, inflation developments have been encouraging.
That said, despite these positive developments, I still believe that we must not declare victory over inflation prematurely. We continue to expect an uptick over the coming months. There’s going to be a reversal of some fiscal measures and of some base effects, and we cannot exclude that there’s going to be a new price spike in energy or food.
Our job is now to make sure that the disinflationary process continues and that we remain on track towards the 2% target. Our monetary policy is working. The restrictive policy is contributing to dampening growth in aggregate demand. Economic growth has been weak over the past several quarters, and it’s expected to remain weak this quarter before gradually picking up next year. This period of below-potential growth is needed to bring inflation back to 2%.
So, I believe we are on track, but we need to remain vigilant.
Are we still on the inflation path you outlined in your September projections?
Let’s see what our December staff projections are going to show. But the recent inflation print has given me more confidence that we will be able to come back to 2% no later than 2025. This is our main objective.
What is your assessment of growth since the September projections?
Some of the hard data we see are not very good. But some of the soft data are giving us hope. The purchasing managers’ indices (PMIs) seem to be bottoming out and they’re even showing a small uptick. Of course, this is from very low levels. But it is in line with our projections. Growth is then expected to pick up gradually next year, mainly due to rising real incomes, which should foster confidence and consumption.
All this will depend, to a large extent, on the development of the labour market, which has been very resilient. We have seen that firms have held on to their labour force in spite of weakening economic growth. This is only sustainable if they expect growth to pick up. If there was a significant deterioration in the labour market, this could put the growth recovery into question and at the same time accelerate the disinflationary process.
But while we do see some softening in the labour market, we do not expect a significant deterioration or a deep and prolonged recession.
Do you see a risk that the rapid drop in credit demand could exacerbate the downturn?
What we’re seeing is that monetary policy transmission is working. There has been a sharp increase in lending rates and a strong slowdown in loan growth. This is exactly what we wanted to see.
Markets are pricing an early spring rate cut but the ECB has guided for steady rates for several quarters. How do you view this discrepancy?
Markets are confident that inflation is going to come down rapidly and therefore they are pricing early and very large rate cuts next year. Central banks are more cautious, and I would argue they have to be more cautious. After more than two years of above-target inflation, we need to err on the side of caution. If you look at our previous communication after the Governing Council meeting, we confirmed that our key policy rates need to remain sufficiently restrictive for as long as necessary to bring inflation back to our 2% target in a sustainable manner. This should happen no later than 2025.
According to our staff projections, the current level of restriction is sufficient to bring inflation back to target within that time frame. Transmission is working – lending growth is slowing, the economy is weakening and inflationary pressures are easing. We are right on track.
But we still need to see some further progress with regard to underlying inflation. The disinflationary process on underlying inflation has only recently gained momentum. We now need to see whether this is sustained.
We’ve seen very strong wage growth and weak or even falling productivity, leading to a sharp increase in the growth of unit labour costs. This is why we look very closely at services inflation in particular, which gives us a good indication of whether this disinflationary process is sustained. We’re going to watch upcoming wage agreements very closely. This will certainly also matter for our monetary policy decisions.
If the current level of restriction is sufficient, does that mean you do not see a need for further rate increases?
The most recent inflation number has made a further rate increase rather unlikely.
What is sufficiently long? Do you also see several quarters of steady rates?
We need to see more data. There’s first likely going to be an uptick in inflation. So, this downward movement of inflation is probably not going to continue for now. And most importantly, we need to see what’s going to happen to underlying inflation, to wage growth, to productivity, to unit profits. In order to be confident that we will sustainably return to our target, we need more time.
Am I reading it correctly that you’re not ruling out a rate cut before mid-year then?
We remain data dependent. That’s the main thing. We have to see what’s going to happen. We have been surprised many times in both directions. So, we should be careful in making statements about something that is going to happen in six months’ time.
What is your view on the timeframe for ending pandemic emergency purchase programme (PEPP) reinvestments?
As President Lagarde mentioned, the Governing Council is going to discuss reinvestments under the PEPP in the not-too-distant future and I’ll leave it up to you to interpret what that means. It’s clear that discussion is going to come. It’s also clear that at some point we’re going to fully end PEPP reinvestments. The amounts involved are relatively small and markets are expecting this to happen, so I think it’s not such a big deal.
Am I correctly reading the mood that even if reinvestments end, there is no appetite for outright sales of bonds in either the asset purchase programme (APP) or PEPP portfolios?
We have never discussed outright sales.
You gave a speech in March in which you made the case for a demand-driven system for the ECB’s new operational framework. How has you thinking evolved since?
What I said in that speech is that a demand-driven system is well-suited for a heterogeneous currency union that may be prone to fragmentation. Such a system also likely limits the size of the central bank balance sheet. Of course, it can be designed in many different ways. What we are doing in our framework review is trying to find a system that implements our monetary policy effectively and efficiently in a way that minimises the negative side effects.
So, the new system has to take into account the specificities of the euro area financial system. It has to be firmly embedded in our legal framework and it should limit our market footprint. But one should be aware that we are starting from a situation of abundant excess liquidity. So whatever framework we choose, money market rates will initially remain close to the floor.
What is the timeline for the balance sheet to shrink to its optimal size?
That depends on various factors that we can’t project perfectly. It also depends on the framework that we will eventually choose. One of the main drivers of the size of the central bank balance sheet is the growth of what we call autonomous factors – banknotes and official sector deposits – and the growth of reserve requirements. These factors already imply that the balance sheet is going to be around three times as large as before the global financial crisis.
In addition, banks could have a higher demand for excess liquidity for regulatory or precautionary reasons. If the outcome of the review was a demand-driven system, the size of the balance sheet would thus also depend on banks’ demand for excess liquidity. This would mean the size would not be determined by us, which is a good thing, because we don’t know precisely what the demand is.
The Federal Reserve has gone with the floor system. Could two of the world’s biggest central banks operate with different frameworks?
I do not see any problem with that. If you look around the world, you see many different frameworks. The Fed has a supply-driven floor, the Bank of England a demand-driven floor, and Sveriges Riksbank a narrow corridor, while many central banks in emerging markets have a classical corridor. So, there is a wide variety of models out there that are tailor-made for specific financial systems.
We need to keep in mind, though, that this only matters far out in the future, because we are starting from a situation where we have a huge monetary policy bond portfolio. The structure of the balance sheet only becomes relevant when it has to grow again. As regards a structural portfolio, I mentioned in my March speech that this could be considered. Also keep in mind that we de facto already have a structural portfolio because some national central banks are holding bonds in their Agreement on Net Financial Assets (ANFA) portfolios.
What do you mean by “far out in the future”? Could it be next decade?
That depends on the decisions we are going to take. If we decided on both longer-term credit operations and a structural portfolio, we would have to think about a potential split. But this really depends on many factors and I do not want to make any predictions.
What is clear is that the balance sheet has to be much larger than it was before the global financial crisis. But, for all the frameworks under consideration, the balance sheet is going to be much smaller than it is now.
Should the ECB introduce new longer-term refinancing operations?
We will discuss the different options available to provide liquidity to the banks, including longer-term operations. But such a facility would have to be different from the targeted longer-term refinancing operations (TLTROs) we were offering during the pandemic, in that it would have to be offered at market rates. From the banks’ perspective, longer-term lending operations are attractive because they provide a certain reliability of funding. And they reach all parts of the banking sector directly. That is very different from asset purchases – when you inject liquidity, it typically ends up with the larger banks and in certain financial centres.
Do you see a case for increasing the minimum reserve requirements, as some of your colleagues advocate?
We had a discussion on minimum reserve requirements in July and we discussed both the calibration and the remuneration. We decided to keep the minimum reserve requirements at 1% but to remunerate them at zero, instead of at the deposit facility rate.
The reason for this was proportionality. With this change, we can implement our monetary policy stance in the same way and equally effectively while paying lower interest to the banks. That was the justification for reducing the remuneration.
The proportionality argument implies that, if we have two options and one of them leads to losses while the other is just as effective in achieving price stability but reduces these losses, then we should choose the option that generates smaller losses.
But let me stress that the minimum reserve requirements are not a tool for adjusting our monetary policy stance. They also have distributional effects – they have the greatest impact on the banks with the highest deposit base, which tend to be the smaller banks.
We are going to discuss the role of minimum reserve requirements in the operational framework review. And until then, we will not take any decisions.
To what extent should profit and loss considerations matter for monetary policy decisions?
Our monetary policy decisions are determined by our mandate. Profit and loss considerations matter only insofar as they affect our credibility and, consequently, our ability to pursue our mandate.
Andrea Enria argued recently that shadow banks need closer scrutiny, and the ECB could theoretically conduct this supervision. If the ECB supervised them, it could also provide them with access to liquidity facilities. Is that needed?
The experience of the pandemic shows that we are able to distribute liquidity across the financial sector without giving non-banks direct access to our balance sheet. At the moment we are not considering opening up our balance sheet to non-banks because there is no clear case for that.
