Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Jana Randow and Alexander Weber on 15 February 2023
17 February 2023
How much closer are we to achieving 2% inflation over the medium term, compared to December?
We are still far away from claiming victory on inflation. A broad disinflation process has not even started in the euro area. If we look at underlying inflation in particular, we are seeing that it is very high and more persistent than headline inflation. Underlying inflation developments play an important role in our thinking.
Energy prices have dropped quite significantly, headline inflation is slowing faster than expected. How will that impact the outlook for core inflation?
We are already seeing that the drop in energy prices is feeding into headline inflation, and eventually it will also feed into underlying inflation. The pass-through from lower energy prices to core inflation may be slower than on the way up, but eventually it is going to happen. What is more important when it comes to medium-term inflation is the development of wages and profits.
If we look at our wage trackers, we are seeing that wage growth has picked up substantially. It is expected to be around 4 to 5% in the years to come, which is too high to be consistent with our 2% inflation target even when taking productivity growth into account. Also, given a longer duration of wage contracts compared to the US and a more centralised bargaining process, one could expect wage growth in the euro area to be more persistent. So wage developments are going to be key for our assessment of underlying inflation and therefore also for inflation over the medium term.
The second important factor is profits. In the past, many firms were not only able to fully pass through their higher costs, but often they were even able to increase their profit margins. So we also need to look at the evolution of profits.
Finally, both price- and wage-setting depend on inflation expectations. Through our determined action, we have been able to keep inflation expectations anchored. We are seeing longer-term inflation expectations broadly anchored at 2%.
One important component in wage demands is past inflation. Would it be fair to assume that wage pressures will abate as inflation eases?
Hopefully. But wage growth has to be consistent with inflation returning to 2%, and that’s what we need to monitor. That said, it is highly unlikely that inflation pressures are going to vanish all by themselves.
Many forecasts see core inflation above headline inflation before long. How would the ECB deal with this situation, given its mandate focuses on the latter?
The attractor of headline inflation over the medium term is core inflation, which is why it matters so much for our monetary policy. We have defined our target in terms of headline inflation, but we know what drives headline inflation over the medium term is core inflation.
Considering all the points you’ve made so far, can you think of anything that would stop the ECB from delivering that half-point hike it has signaled for March?
Given the current level of policy rates and the level and persistence of underlying inflation, a rate hike by 50 basis points is necessary under virtually all plausible scenarios in order to bring inflation back to 2%. There is no inconsistency between our principle of data-dependency and these intentions because it is very unlikely that the incoming data is going to put this intention into question.
Where will rates go after March, based on information available today?
Let me explain how I see our reaction function. It comprises two decisions. The first is how far we need to raise rates so they become sufficiently restrictive. The second decision is for how long we need to keep interest rates at this restrictive level.
Let’s start with the first question, the determination of the terminal rate. Conceptually, one would like to look at the neutral rate, but that concept is of little practical use because we are not able to estimate it reliably in real time. Instead, we need to look at incoming data for evidence that our policy is being restrictive.
There are three stages in the transmission process: The first is from our policy measures to financing conditions. There we have seen quite a substantial tightening. The second stage is from financing conditions to aggregate demand, and the third stage is from aggregate demand to inflation.
What really matters for our decision on the terminal rate is the second stage. Are our monetary policy measures effective in slowing the growth of aggregate demand? Recent data show some weakening of the economy towards the end of last year, but the question is whether, and to what extent, this was driven by our monetary policy or whether it was predominantly a consequence of the energy price shock. The bank lending survey, for example, shows a sharp tightening of credit standards. But the largest part of this tightening is driven by changes in banks’ risk perception and risk tolerance. Banks’ cost of funds have played only a very small role so far. And now that the economy is proving more resilient, part of these factors may even reverse and counteract our intentions to reign in loan demand. Therefore, it is not so easy to judge whether our measures are already restrictive.
The other factor is that the labour market is very strong. We have seen marked growth in employment in the fourth quarter. Surveys show that hiring intentions are strong and rising. The only place where we already see unambiguous evidence of transmission is in the housing market, which is most sensitive to interest rates. Mortgage growth has fallen, the intentions to buy houses are going down, and we are seeing a weakening of housing investments. We do not yet see such trends more broadly. I think that in May we will have a clearer picture on that.
Now, on the second question, how long do we need to keep interest rates at a restrictive level? The answer is: until we see robust evidence that inflation — and in particular underlying inflation — is going back to our target of 2% in a timely and durable manner. A turning point in underlying inflation is not sufficient because this turning point is likely driven by the gradual pass-through from lower energy prices to underlying inflation rather than the more persistent components. Over the medium term, inflation will mainly be driven by wage and profit developments.
Can we expect to get some guidance in March on the decision on interest rates in May?
I cannot give you an answer because I simply do not know. We shifted towards a meeting-by-meeting approach and data-dependency because of the high uncertainty. But it can be useful to give an idea about the direction of travel.
What would you need to see to consider slowing down rate hikes to 25 basis points in May?
I would need to see that our monetary policy is becoming restrictive, which should show up in lending markets, in labour markets, and in the various aggregate demand components.
How do you deal with time lags in the transmission process?
This rate-hiking cycle is quite unusual due to its speed and the synchronicity across many major economies. There is a lot of uncertainty about the transmission process and time lags, and this is precisely why we need to look so carefully at the incoming data. There are reasons to believe that transmission may be weaker than in previous episodes. We have seen a notable shift from variable towards fixed rates in mortgages. We have also seen a shift towards longer maturities in the bond market. In addition, our surveys suggest that firms see an urgency to invest in digital and green technologies. And then we have the very strong labour market, which means that the usual transmission through a decline in employment may not work in the same way. All these factors would suggest that there could be a lower sensitivity of aggregate demand to changes in interest rates.
Does that mean you will need to raise rates higher than otherwise to achieve results?
We may have to act more forcefully if transmission turns out to be weaker.
Are you concerned at all of cliff effects should transmission channels suddenly unclog?
The question is whether transmission is weaker or delayed. I would say there are arguments for it being weaker. But even if it is delayed, we always have the possibility to respond. We have the option to lower rates again if we get the impression that our monetary policy stance is getting too restrictive. From today’s perspective, that is nothing I foresee anytime soon.
Economists’ forecasts for the terminal rate are at around 3.5% by June. The market is pricing a very similar outcome. Is this something you think is mostly right or do you have fundamentally different ideas from today’s perspective?
Markets are priced for perfection. They assume inflation is going to come down very quickly toward 2% and it is going to stay there, while the economy will do just fine. That would be a very good outcome, but there is a risk that inflation proves to be more persistent than is currently priced by financial markets. As regards the terminal rate, we need to look at the incoming data to see how far we need to go.
You’ve argued recently that higher credit costs mustn’t stand in the way of investing in the green transition. How does that relate to the ECB’s ability to dampen demand to get inflation down?
Interest rates are unlikely to be the main hurdle for the green transition. The hurdles are coming from the government side. There remain many bureaucratic hurdles, strong subsidies for fossil fuels, uncertainty about future government policies as regards the green transition, and a lack of a green investment initiative from the public side. And we still lack a true capital markets union, which would be important for the green transition.
The other question is whether the increase in interest rates puts a brake on the green transition by suppressing demand. And there the answer is that the green transition in my view can never work in an inflationary environment, when there is a risk that inflation is getting out of control. We have seen how much uncertainty is created by high inflation. Uncertainty puts a brake on investment. Our best contribution to fostering investment — in the green transition but also in other areas — is to get back to price stability and create, as far as we can, a stable macroeconomic environment.
So the best solution is fighting inflation quickly now with restrictive rates, making investments less attractive in the very short term, but then lowering borrowing costs so the transition can go on?
That is one point. But of course governments also have an impact on the composition of demand. The current fiscal measures do not channel demand to areas that are most needed for the green transition. There is very little public investment, many subsidies are directed towards supporting fossil fuels, and the broad-based stimulus supports consumption. There is a role for the government to impact the composition of aggregate demand, which could – through the effect on potential growth – also support price stability. What governments do matters for the medium-term inflation outlook. And what we have seen so far was not very supportive of price stability.
From March, you’ll start to reduce your bond holdings. Is it possible to say how much those roll-offs will contribute to policy tightening?
Let me give you the rationale for why we are doing quantitative tightening (QT). The first reason is that the current high level of excess reserves is simply not necessary to implement our monetary policy and steer money market rates. The second point is that a large balance sheet has side effects. Our large footprint in financial markets can hamper market functioning. We are seeing collateral scarcity, which is partly related to our footprint in the market. And the third argument is that our large balance sheet provides significant accommodation, which is not in line with our monetary policy stance.
At the moment, interest rates are our key policy tool. However, by doing QT, we can provide additional tightening. But I would not see interest rates and QT as perfect substitutes because they are acting on different parts of the yield curve. I see the two tools, in the current phase of the tightening cycle, as being complementary. They are working in the same direction. How big the tightening impact is, is an empirical question. Quantitative easing (QE) was working through various channels and not all of them may still operate in the same way. There is, for example, a signaling channel which may be weaker, or even absent, under QT. But other channels, like the portfolio rebalancing channel, could be expected to work quite symmetrically. Therefore, estimates on the impact of QE could also broadly apply under QT. There is not so much empirical data on QT that we can use, but I would say that there is a certain symmetry.
Do you expect the pace of roll offs to be stepped up after the initial starting phase?
We want the pace to be measured and predictable and our current announcement goes until the end of the second quarter. QT could be sped up after that, as is currently priced in financial markets. But this still needs to be decided.
We are confident that QT is going to run smoothly. We are analysing the risk-absorption capacities of financial market participants. What we see at the moment is that investors are returning to the bond market, which is becoming more attractive due to higher yields. This is even going to increase when we are getting closer to the terminal rate. Of course, it also matters what is happening in the rest of the world. But so far we believe that QT is going to run rather smoothly.
How much does the level of long-term interest rates matter when you determine the pace of QT in the coming months?
We need to reduce the balance sheet and we want to do so in a measured and predictable way without causing any disturbances. So, it is not so much determined explicitly by stance considerations because this is not our main stance tool, but it is decided in a more technical way. It is clear that QT tends to have an effect on the longer end of the yield curve. But it is not that we are steering the slope of the yield curve. That is not the way we think about it.
You said recently that you’d expect the ECB to hold a structural bond portfolio in the future. Is it possible to estimate how big that is, and how long it will take the ECB to get there?
We are currently reviewing our operational framework and we hope to finish that review by the end of the year. One of the questions we need to answer is whether we want to keep the current de facto floor system or whether we want to return to a corridor system for steering interest rates. That has implications for the size of our balance sheet in the steady state. But even under a floor system, there are different approaches and you could run a floor system with a very large balance sheet or with a somewhat smaller balance sheet. These are still open questions that we need to look at. There are arguments in various directions. It is a technical, but very important discussion that we will have over the course of this year. So far I cannot tell you where we are going to end up. What is clear is that the current process of QT is gradual, so we are still quite far away from the point where the size of our balance sheet may affect our ability to steer short-term interest rates. This gives us a bit of time, but it is important, at some point, to give an indication where we think the balance sheet is going to end up.
