Interview with Finance

Interview with Luis de Guindos, Vice-President of the ECB, conducted by Albina Kenda

9 November 2023

The ECB did not change its key interest rates at its October meeting, interrupting the series of ten consecutive interest rate increases that had brought rates up by 4.5 percentage points since July 2022. A few days later Eurostat announced that euro area headline inflation had fallen to 2.9% in October. Does this mean that interest rate hikes are over?

It means we are maintaining interest rates at their current level, and we believe that this will substantially contribute to bringing inflation back down to the 2% level we define as price stability.

The evolution of inflation has been positive overall: it was above 10% only one year ago and it has now fallen to 2.9%. At the same time, core inflation has also been moderating. But we have to be prudent and cautious, as there are some risks around the outlook for inflation over the next few months. We will continue taking a meeting-by-meeting and data-dependent approach to interest rate decisions.

Euro area GDP was down by 0.1% in the third quarter, and economists think inflation may rise again over the coming months as the positive base effect will progressively fade out. At the same time, there is a risk of another commodity price shock arising from the situation in the Middle East. If the ECB finds itself at a crossroads, will it prioritise growth or inflation?

Our primary task is to maintain price stability and to bring inflation back down to 2%. Unlike some other central banks, the ECB does not have a dual mandate.

At the same time, we need to look at other economic variables that may affect inflation. We expect that growth will stagnate in the second half of the year and that the fourth quarter will not differ much from the third. Our most recent projections indicated some downside risks to growth; some of these risks have now started to materialise and this will have an impact on inflation.

Our September projections foresee that euro area inflation will reach our target in 2025, with some fluctuations caused by base effects. However, we believe that, if interest rates are maintained at their current levels, inflation will continue to fall and converge towards our target.

The ECB will publish new forecasts in December. Will these be more or less the same as in September, or are you expecting upward revisions for inflation and downward revisions for growth?

It might be premature to say it, but leading indicators point to the growth outlook being somewhat more negative than we previously projected. As regards inflation, the evolution may not be very different from what we projected in September.

You mentioned the meeting-by-meeting and data-dependent approach to decision-making. But in October the ECB said it considers its key interest rates to be at levels that will make a substantial contribution to lowering inflation, provided they are maintained at those levels for a sufficiently long duration. What is meant by “sufficiently long”?

This means a period of time that takes into account the potential lags of monetary policy. Recent data on headline inflation figures have been quite positive, and we are glad to see that underlying inflation is coming down, as one of our main concerns in the past was how sticky core inflation was.

I would not define “sufficiently long” as used in our monetary policy statement as a concrete period of time. We will need to determine this on the basis of data. In our decision-making we will also have to take into account the high level of uncertainty surrounding geopolitical risks related to the conflicts in the Middle East and in Ukraine.

But what kind of data would the ECB need to see to start reducing interest rates rather than simply keeping them at restrictive levels?

We are not there yet. We will see how things evolve month by month, but our approach now is to keep interest rates at this level long enough to reach our target. Any discussion about lowering interest rates is clearly premature.

To what extent did the ECB’s monetary policy take into account not just the euro area average but the situation in individual Member States, as there are significant differences among them, also in their level of inflation. According to Eurostat, in October Slovakia recorded the highest inflation rate of 7.8%, Slovenia registered 6.6%, while the Netherlands and Belgium recorded deflation of 1% and 1.7% respectively.

We have seen disparities among euro area countries in their economic and financial structures, in the weight of services in their economies and not least in their proximity to the conflict in Ukraine.

There are always differences in inflation and growth, but the ECB sets monetary policy for all euro area countries. Our measure of price stability is defined for the euro area as a whole.

In dealing with the disparities, it is important to consider the effects of fiscal policies. With regard to base effects, we have to look at how governments have introduced, and have started to withdraw, support measures to mitigate the shocks of the energy crisis. Fiscal policy will be the key element in bridging the gap in inflation rates across countries. But our monetary policy is single.

The ECB is now looking more closely, in line with other central banks, at core inflation, which excludes energy and food prices. What are ECB’s main concerns in this regard? ECB President Christine Lagarde said this summer that profit margins contributed almost two-thirds to domestic inflation last year. Almost nobody mentions this anymore, but there is now a discussion about the effects of wage increases.

It is essential to focus on core inflation, for which there are several risks. First, there may be another energy shock that would eventually affect both headline and core inflation. Second, there is the evolution of the euro exchange rate, which we do not target but which nonetheless plays a role in inflation. And finally, there are unit labour costs.

Rising labour costs result from two factors. The first one is wage developments, with wage growth in the euro area now at just over 5%. The second is productivity, which is very low and has been declining because employment growth has been outpacing output growth.

It is true that profit margins grew even faster than unit labour costs last year. This year, however, we are seeing a moderation in profit margins, while labour costs are on the rise.

Our expectation is that part of the increase in labour costs will be absorbed via profit margins, meaning that not all of this increase will be passed through to final prices.

At the ECB, you are exploring the use of artificial intelligence to deepen your understanding of inflation. What will you do differently from what you have been doing so far and what do you hope to achieve? We know that, while not the only one, you have been wrong as far as the inflation forecast is concerned.

Our colleagues working with statistics deal with a lot of information, a lot of data on the financial system and the real economy, so any instrument that helps us manage this monumental amount of information is very useful.

So we are continually looking for algorithms that can give us a better understanding of what is happening in the economy, in the financial system, and a way of factoring in all the underlying tendencies that are embedded in the data we analyse.

There have been warnings that in its fight against inflation the ECB has been focusing only on the demand side of the economy, while supply-side factors also contribute to inflation. Is a more balanced approach warranted for the future, bearing in mind the pressures that may stem from geopolitical tensions, the demographic picture and the implications of the Green Deal? The economy has already been disrupted, is monetary policy next?

Sometimes it is important to stress that monetary policy works through interest rate increases, through the transmission of monetary policy decisions to financing conditions and then through the impact of financing conditions on aggregate demand.

So, monetary policy and the transmission of its decisions aim to influence aggregate demand, consumption and investment. Monetary policy cannot deal with supply-side issues. These need to be addressed through structural policies and fiscal policies.

Let me add that it’s not only the origin of inflation that’s important, but also the possibility of second-round effects, which can make the situation much more complicated, with a possible price-wage-profit spiral. In particular, we need to avoid de-anchoring inflation expectations, as this could lead to unnecessary additional tightening of our monetary policy stance.

It was announced a while ago that the ECB, in cooperation with Eurostat, would include housing costs in the calculation of inflation. How far along is this project?

This was part of the ECB’s strategy review, and it was clear that housing costs need to be taken into account when measuring inflation. However, such costs need to be well calibrated in the index, and this is mainly Eurostat’s responsibility. Including the cost of owner-occupied housing in the measurement – known as the owner-occupied property cost – contributes to the calibration of inflation. We are very willing to cooperate with Eurostat and provide our input and insights.

So there is no deadline?

It is not up to us. But there is a need for harmonised action at EU level, not just in the euro area, and this takes time.

The ECB has dealt with record-high euro area inflation by raising interest rates at a record pace. In the banking systems of several countries, including Slovenia, borrowers have felt the effects of this policy much more than savers. Is this also due to the consolidation of the banking market and the subsequent lack of competition?

You are right about the effects. As you know, we have made it crystal clear: whenever we raise our key interest rates, this increase should be passed on to all sides of the market.

The current situation can be explained by several factors. First, there is excess liquidity, so banks haven’t been under pressure to raise the remuneration of deposits. However, liquidity conditions are becoming less and less comfortable for European banks – there have been changes to the parameters for long-term liquidity lending to banks under the targeted longer-term refinancing operations and changes to our bond-buying programmes, so the decline in liquidity will continue. Second, banks are always slower to change their pricing policy for deposits than they are for loans.

But there is a slow-but-steady increase in the remuneration of deposits, particularly time deposits. We believe that this process will continue. We are monitoring it very closely and, I’ll say it again, when we raise interest rates, we are not only raising them for borrowers, but for savers too, because otherwise the transmission of monetary policy would be incomplete.

Given that deposit interest rates lagging behind lending rates has resulted in considerable growth in banks’ net interest income, could you say that banks are pursuing short-term goals instead of long-term sustainable business goals, especially as you said yourself that the ECB is now determined to reduce excess liquidity in the system?

You’re right – the profitability of European banks has improved recently owing to the increase in key interest rates and an improvement in profit margins.

However, this has not been reflected in the market valuation of banks because markets believe that this improvement in profitability may not be sustainable over time. First, because the economy is slowing, which could lead to an increase in the stock of non-performing loans. Second, because the drop in demand for loans would reduce banks’ revenues. And third, because the cost of funding for banks is rising.

So I think that it’s quite obvious that, despite the improved profitability of banks, there are doubts about how sustainable this will be in the longer term.

What are the challenges to financial stability in the euro area now that we are in a phase of economic slowdown? What is the situation regarding insolvency proceedings, non-performing loans and risks to the banking system stemming from the real estate market? In Germany, residential property prices fell by around 10% in the second quarter. Do you expect a correction elsewhere as a consequence of the ECB’s monetary policy tightening?

When interest rates go up, the financial stability situation changes. The first factor we have to look at is valuations of financial assets and real estate assets.

One of the main risks we see in terms of financial stability in the euro area is the possibility of a disorderly adjustment of asset prices and the implications it could have for banks.

It should be stressed that banks are in a good position in terms of profitability, capital and liquidity. But we cannot be complacent because, as I said, there are some doubts about how sustainable this improvement is going to be over time.

There is another factor for financial stability. We look very carefully at non-bank financial intermediaries, particularly real estate mutual funds. In this regard, we have seen a significant drop in commercial real estate valuations. This decline had set in before the start of the monetary policy tightening but has now accelerated following the rise in interest rates. A number of non-bank financial intermediaries have seen very steep declines, particularly in commercial real estate.

In addition to economic cooling, we are also witnessing a housing crisis across the EU. How do you respond to the criticism that the ECB’s monetary policy has contributed to this, first with bond purchases that lowered bond yields, which led institutional investors to turn to the property market for returns, and now by increasing borrowing costs, which has caused many building projects to be postponed or completely abandoned?

We can be criticised for being too lenient or for being too tough. But, if I may say, I don’t think it’s fair to be criticised for both things at the same time.

There were reasons why we had a very expansionary monetary policy – think back to the pandemic and the decline in GDP. I think that without our monetary policy, the situation would have been much worse. Going back even further, to the era of quantitative easing, you will recall that our monetary policy averted a deflationary crisis. However, sometime after 2021 inflationary pressures started to emerge, and we had to respond.

Monetary policy has to deal with the evolution of inflation and our primary focus has always been on price stability. Sometimes there are lateral effects. But there are also other policies to deal with a potential real estate bubble, such as fiscal and macroprudential policies.

In other words, you are looking at developments in the real estate market through the prism of the financial stability of the banking system.

For sure. My point is that monetary policy has to be focused on price stability. However, there are other instruments available, like fiscal and other policies. In the event of real estate market growth that is not fully aligned with fundamentals, macroprudential policies can be applied, bank capital buffers can be increased and borrower-based measures can be used to limit excessive growth in real estate lending. A range of policies are available.

What are the latest trends in the credit situation in the euro area?

The evolution is quite clear: financing conditions have tightened as a result of our monetary policy decisions, resulting in a decline in credit demand, which can be seen for both households and firms. This is how monetary policy works.

My last question is on the tax issue. Banks are reporting high profits, largely due to higher net interest income. As a result, several governments have decided to levy additional taxes on them. Why is the ECB not in favour?

Our decision is based on two pillars. The first is that this kind of tax should not impair lending or the transmission of monetary policy measures to the system. The second is that such a tax should not damage the solvency of banks, as this could have medium-term consequences for banks that are not well capitalised.

We have already issued opinions for Lithuania, Spain, Italy, and now Slovenia. The taxes are not all the same, but each opinion points out that the tax should not impair lending and should not damage the solvency of banks.