Interview with De Tijd

Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Wouter Vervenne and Kris van Hamme on 31 May 2023

7 June 2023

Please note that the interview was conducted in English and translated into Dutch and French. In case of discrepancies between the versions, the English version prevails.

People are fed up with inflation. What hope can you offer them? When will inflation return to 2%?

Headline inflation in the euro area has come down relatively quickly after hitting a peak of 10.6% in October of last year. However, underlying inflation (which excludes volatile food and energy prices, Ed.) is more persistent and remains high, with services playing a key role due to the relatively strong impact of wage costs on inflation in these sectors. Rising food prices are also driving inflation, but we expect food inflation to fall in view of the global slowdown in agricultural commodity prices.

According to our March projections, inflation will return to our 2% target only in 2025. This would mean above-target inflation for around four years – a very long time. One important question is how this may affect inflation expectations of businesses and households, and hence firms’ price setting and wage negotiations.

Wage agreements can have a prolonged effect on inflation due to their long duration. That’s why it is so important to keep inflation expectations firmly anchored at our target and bring inflation back to 2 percent as quickly as possible.

You have said that food prices are still quite high. And that is the case while the United Nations’ Food Price Index peaked one year ago. What’s going on?

It is a bit comparable with energy prices. There, we have seen a surprisingly fast pass-through of rising wholesale prices to consumer prices, followed by a more gradual pass-through on the way down. We may see a similar development in food prices. This shows how difficult it is to forecast how price changes will be passed on to consumers.

In the longer term, we may be facing recurring periods of strong food price increases due to climate change, which leads to more frequent droughts, extreme weather events and failed harvests. We are therefore monitoring the evolution of food prices carefully. This is also a sensitive social issue.

Another sensitive issue is “greedflation”, where businesses take advantage of the inflationary environment to increase their profit margins, thereby stoking inflation. You have since recognised that the ECB has paid too little attention to corporate profits. Did this surprise you?

If one looks at the drivers of domestic inflation, both wages and corporate profits have recently played an important role. Many companies were not only able to fully pass on their higher input costs to customers, but they even increased their profit margins. This was to a large extent owed to the specific pandemic situation, when after the reopening of the economy strong demand outpaced constrained supply in a number of sectors. This gave firms higher pricing power.

This can lead to what I call a profit-wage-price spiral, as opposed to a simple wage-price spiral (whereby rising wages and prices chase each other higher, Ed.). First, many firms raised their prices over and above their cost increases. Trade unions are now trying to negotiate higher wages, facilitated by the tight labour market and higher corporate profits. In the case of Belgium, there is even automatic wage indexation. The question then is how businesses will respond. Will they continue to fully pass on higher costs, or even more than that, or will they partially absorb them through lower profit margins? That will largely depend on how strong the demand for goods and services remains.

That is where the central bank has a key role to play. Our monetary policy works by dampening growth in aggregate demand (through higher interest rates, Ed.), which makes it harder for firms to pass on costs and reduces workers’ bargaining power to push through higher wage demands.

Is the policy tool of higher interest rates not a rather blunt instrument to hammer down inflation caused by rising profit margins?

It is ultimately a distributional question how to share the burden of higher energy costs between labour and capital, and this question is up to the social partners and governments. It is not up to central banks to decide this. We must use the tools we have.

The ECB was one of the last central banks to start raising rates to tackle inflation. Was it not too late?

The tightening process already began well before the first rate hike in July 2022. In December 2021 we announced ending some of our asset purchases. Hence, rates in financial markets increased much earlier than July 2022. Moreover, monetary policy needs to respond to the economic situation, which is not the same everywhere. That’s why the ECB started hiking later than the US Federal Reserve.

With hindsight, one could say that we should have acted earlier. But in 2021, we were still in the middle of the pandemic. We were faced with the spread of the Omicron variant of the coronavirus and a great deal of uncertainty. The Russian invasion of Ukraine stoked inflation further. It is difficult to say how inflation would have evolved without the war.

Over the last year the ECB has raised interest rates at a rapid pace. When can we expect to see a pause in the hikes?

Our interest rate decisions are data-dependent and are based on three elements: the inflation outlook, the evolution of underlying inflation and the transmission of our monetary policy to the economy. The latter occurs in three stages: A rise in the policy rate first has an impact on financing conditions, then on the real economy, and ultimately on wages and prices.

Staff analysis suggests that monetary policy transmission is proceeding and that the impact of our tighter monetary policy on inflation is expected to peak in 2024. However, there is great uncertainty over the strength and the speed of this process. The estimated impact varies greatly depending on the models used and, in particular, on the role expectations play in consumption and investment decisions. The less important the role of expectations, the weaker is generally the transmission of monetary policy. Moreover, given the current shortage of workers, one could expect monetary policy transmission to be weaker than usual. Finally, loan contracts with fixed-term rates over long periods have become more prevalent. As a result, it may take longer than was previously the case to see the impact of our policy.

To deal with this uncertainty, we try to balance the risks of doing too little against the risks of doing too much. Given the high uncertainty about the persistence of inflation, the costs of doing too little continue to be greater than the costs of doing too much. The reason is that once inflation has become entrenched in the economy, it becomes much more costly to fight it. We have more ground to cover. It will depend on the incoming data by how much more rates will have to increase.

Markets are expecting two more rate hikes of 25 basis points each. Is that realistic?

That will depend on the incoming data. Let me be very clear: A peak in underlying inflation would not be sufficient to declare victory: we need to see convincing evidence that inflation returns to our 2% target in a sustained and timely manner. We are not at that point yet.

In some euro countries, including Belgium, banks are being criticised because their deposit rate is much lower than the ECB rate. President Lagarde recently said that she supported the call by the Dutch finance minister to increase the interest rate on savings. Do you agree with that?

The pass-through of the ECB’s interest rate increases to bank lending rates was very quick, while the pass-through to deposit rates is much slower. But there are differences across different types of deposits. Deposit rates for corporates and time deposits reacted more strongly. Much depends on how customers react. If depositors start to shift their money from overnight deposits to higher-yielding alternatives at other banks or in financial markets, banks will likely respond by increasing interest rates to retain deposits. If customers prefer to leave their savings in overnight deposits because they like having liquidity and ease of payment, it is not surprising that banks are not adjusting their interest rates.

As President Lagarde has said, this matters for monetary policy transmission, which works not only through lending rates but also through deposit rates. Higher deposit rates provide an incentive to save more (and thus slow down consumption, Ed.). From a monetary policy transmission perspective, it’s desirable that the increases in the ECB rates are passed through to deposit rates. But we cannot make the banks offer higher rates, this is a business decision.

The drawback is that higher interest rates on deposits erode bank profitability, as the sector itself warns. Do you see a danger for financial stability?

Bank profitability has recently increased significantly, although I agree that higher rates on deposits and other bank funding will have a dampening impact over time. But banks have to manage their interest rate risk themselves. We have recently seen striking examples of banks in the United States that failed to manage that risk properly, even though it’s one of the most fundamental risks in banking.

The situation in the euro area appears to be better, thanks to banks‘ high capital and liquidity ratios. But there is no room for complacency. The rise in interest rates has changed the macroeconomic environment fundamentally and exposed the fragilities in the financial system that built up over the period of very low interest rates. The Financial Stability Review published last week highlights those risks. Some asset prices, including real estate, may come under pressure. Higher indebtedness of households, firms and sovereigns tends to increase the vulnerability to higher interest rates. And banks and non-bank financial institutions face liquidity and interest rate risks.

Aren’t the central banks responsible? Leading economist Raghuram Rajan recently stated that extremely loose monetary policy had made the financial system vulnerable by encouraging speculation. Would you agree?

Central banks always have to look at the side effects of their monetary policy actions, including the risks for financial stability. One of the objectives of our bond purchases was to incentivise higher risk-taking in the economy. We need to analyse in more detail how that has affected financial stability risks over time and, in future, we may need to better balance the benefits against the side effects. It’s clear that the fragilities are partly related to a long period of low interest rates, which however was not only due to monetary policy but also to structural factors.

In the past, tightening monetary policy after a long period of cheap money has often triggered a banking crisis. Do you think further mishaps can be avoided?

The banking sector is robust, and the economy has so far proven resilient, even though there are some signs of slowing growth. The euro area economy is subject to countervailing forces. On the one hand, it is benefiting from falling energy prices, fading supply bottlenecks and still expansionary fiscal policy. On the other hand, tighter monetary policy has a dampening effect. There is a striking divergence between the weak manufacturing sector and the strong services sector – a global phenomenon. At present we do not expect a recession in the euro area. Negative growth in Germany in the first quarter of 2023 was mainly driven by a marked decline in government spending. The labour market remains strong and unemployment is at historical lows. Our March projections pointed to a soft landing of the economy. But we cannot be sure that it will really work out that way.

You mentioned fiscal policy, which has been very accommodating since the pandemic. Doesn‘t that hamper your fight against inflation?

Fiscal policy in the euro area as a whole is still expansionary and this fuels inflationary pressures. Monetary policy then needs to be more forceful to counteract that. We have been stressing for some time now that governments should focus on expanding the supply capacity of the economy in order to boost productivity (through education, infrastructure, the labour market, Ed.). That would help dampen inflation. But that is not what is happening in most countries.

Speaking of forceful policy: are there still any hawks at the ECB? German central bankers like yourself are typically thought to support a rigid and strict policy, whereas you are known as a pragmatic central banker who looks at the data and is not afraid to change her mind.

We all look at the incoming data to take the right decisions. But the data can be interpreted in different ways, which is why we have extensive discussions. Our objective is to take balanced decisions that are not based on ideology.

Can you give an example of such an extensive discussion within the Governing Council?

We had a thorough discussion on the pass-through of energy price changes to the economy. We saw a very fast pass-through of rising energy prices to consumer prices. The question was how quickly this would be reversed when energy prices were coming down and whether one could expect a full reversal or whether the reaction would be asymmetric. To this end, we looked at the empirical evidence on previous episodes in order to have a rational debate.

What about the ECB’s own inflation models, which have failed to forecast inflation for years now? How is the drive to improve these models going?

Our inflation target is defined over the medium term, so we must be forward-looking. Therefore, models are an indispensable part of our toolkit. But we must acknowledge that they have not always performed very well in the past few years. I draw two conclusions from that: first, we have to be aware of our models’ limitations; second, we have to try to improve them as much as possible.

Starting with the limitations: we need to be more transparent about the uncertainties surrounding our projections. These might stem, for example, from changes in historical patterns or from different models predicting different outcomes. Moreover, the risk of a de-anchoring of inflation expectations is often not captured by the models. Finally, we need to communicate more clearly that no model can predict exogenous shocks, such as a pandemic or a war.

To improve the models we need to analyse the causes of our projection errors and look at whether we can modify the models accordingly. That is an ongoing process.

Will greater transparency about the uncertainty of your projections not undermine the effectiveness of monetary policy?

I don’t think so. By stressing the point estimates of our forecasts we give the illusion of a degree of precision that we can never reach. Rather than constantly explaining the inaccuracy of the projections, it would be better for our credibility if we published them with confidence bands. Transparency will strengthen our credibility, although I don’t deny that it is a challenge to communicate clearly on this topic.

One other option, which we used during the pandemic, is to present different scenarios. That can be very useful during exceptional situations.

How do you see inflation evolving in the longer term? Will structural forces such as deglobalisation and climate change push us towards a world with higher inflation?

Our projection models typically don’t capture structural trends in the economy; we analyse those trends through a separate exercise, which then partly feeds into the models. The pandemic and the war in Ukraine have clearly led to structural changes, one of the biggest being geopolitical shifts, which may imply a decline in globalisation. This may partly reverse the process that we have seen when China entered the world market, which raised global supply and competition, and gave western firms the opportunity to offshore activities (and profit from China’s lower wage costs, Ed.), thereby creating downward pressure on inflation. We may now see the opposite development.

A second major structural change is the green transition. I expect that this will lead to higher inflationary pressures through three channels. The first is the greater frequency of natural disasters, which I call “climateflation”. The second is higher prices of fossil fuels – “fossilflation” – during the transition phase, caused by taxes on carbon emissions and lower investments in the fossil fuel sector. Finally, the shift towards renewable energies leads to higher demand for certain metals and minerals, which I call “greenflation”.

There are other trends, too, such as the demographic change. The effect that this will have on inflation is still subject to a lively debate. We’ve seen in the past decade that ageing societies have tended to save more and spend less, which dampens inflation. The question is whether the elderly, or their heirs, will spend these savings now. Changes in the labour market could also have a significant impact on inflation, with a decline in people of working age pushing up wages, unless countered by higher immigration.

On top of that we have new technological developments such as the artificial intelligence (AI) revolution. Past experience shows that such developments typically dampen inflation by raising productivity. Considering all of those structural forces together, I would tend to see structurally higher inflation pressures in future.

What does this mean for monetary policy? Will it need to be adjusted – including the inflation target – to deal with this new reality and avoid misaligned policy?

Supply side shocks have a strong impact on monetary policy. Often, we cannot simply look through such shocks, but we need to deal with them in line with our mandate of price stability. We are not even thinking about thinking to change our inflation target.