Interview with Politico

Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Johanna Treeck on 20 April 2023

24 April 2023

Since the last policy meeting, core inflation rose along with market-based inflation expectations and still some of your colleagues say that we should slow tightening. Is that also your view or are you open for another 50-basis point move in May?

Let me start with my general view on recent inflation developments. We are seeing a change in the drivers of inflation. It started with supply-side shocks – bottlenecks and rising energy prices –, which are now fading, while at the same time the demand-side factors are gaining importance. The macroeconomy has proven quite resilient. Industrial production is expanding. The services sector is recovering pretty quickly and wage growth is picking up. What happens to inflation is going to depend on the relative importance of these different factors.

Headline inflation is coming down relatively quickly, due to the sharp decline in energy price inflation. But core inflation continues to surprise on the upside. It shows a very strong momentum, and it stands at a historical high. Given the persistence of underlying inflation, plus the very strong momentum in food inflation, it’s far too early to declare victory on inflation.

People talk a lot about a potential peak in core inflation. I would not overemphasise the peak as such, because what really matters is that inflation is returning to our two percent target over the medium term. We need to see a sustained decline in core inflation that gives us confidence that our measures are starting to work.

Concerning the May meeting, we made it very clear that the decision is going to be strictly data dependent. So, we are going to look at all the available data at that point in time. The data we have so far shows that inflation is higher and the economy more resilient than projected.

But we’re also seeing first signs of transmission of our interest rate hikes. Already before the banking turbulence, there was a slowdown in loan growth. The recent financial turbulences have led to higher uncertainty and are likely to lead to a further tightening in financing conditions. This certainly needs to be taken into account when assessing the transmission of the measures that we have already taken.

So I would say it’s clear that further rate hikes are needed, but the size of the rate hikes is going to depend on the incoming data.

Does that imply that 50 basis points are not off the table for you?

Data dependence means that 50 basis points are not off the table.

You said there is an over emphasis on a peak in core inflation. Do you expect core inflation to peak soon or is there a pronounced risk that core inflation could surprise on the upside time and again just like headline inflation did last year?

So far, core inflation has continued to move up. There is a lot of uncertainty, and this is why we really need to look at the incoming data.

I think it’s quite likely that core inflation is going to peak over the coming months, but it’s not clear that that is going to happen very soon. And, again, you are putting a lot of emphasis on the peak. The peak is a single data point. If core inflation is reaching a peak, but it remains very high and very persistent, the information content of that data point may be relatively limited. So what we really need is confidence that it’s actually coming down in a sustained manner.

How comfortable do you feel with the current terminal rate expectations of around 3.85%?

We’re data dependent, that means that also the terminal rate will depend on the incoming data. If I cannot tell you what’s going to happen in the next meeting, I certainly cannot tell you where the terminal rate is going to be. Interest rates must be set from meeting to meeting.

You will still have an assessment based on your baseline scenario even if the decision is data dependent?

I’m comfortable with the view that further rate hikes are needed. And beyond that, I’m not going to make any further predictions.

President Lagarde said in a recent speech that emerging geopolitical tensions could push up inflation. Do you share concerns over an additional source of price pressures?

There are different aspects to be considered. One is the current economic development in China, which is stronger than expected. This is going to have an impact on global growth, and hence on inflation. That is the story in the short run.

I do not think geopolitical fragmentation is a short-term story, however. It affects the longer term. And the longer term is always more difficult to assess. I can see that geopolitical fragmentation has an impact on monetary policy to the extent that it affects the natural rate of interest, r*, and inflation.

On r*, reshoring could lead to an increase in capital demand, which could go along with productivity increases, which would tend to increase r*. Geopolitical fragmentation could also mean that capital supply is coming down because capital does not flow as easily across regions, which would also speak in favour of a higher natural rate.

On inflation, the entry of China into the world economy was a key disinflationary factor over the past decades. If that reverses, the effect on inflation could also reverse. That could be an important factor. Fragmentation could also lead to higher pricing power of firms, which could drive up inflation. On the other hand, higher productivity growth, if it were to materialise, could have a disinflationary effect. Overall, it’s relatively hard to predict what precisely is going to happen.

So, the possible inflationary pressures stemming from geopolitical tensions is nothing that concerns you in the near term to the extent that you might consider adjusting your ECB staff forecasts?

No, it’s a longer-term development. In the short run, the recovery in China has a direct impact on our projections, although I don’t expect it to fundamentally change the inflation outlook.

Are you confident that there will not be a recession in the Eurozone?

According to our most recent projections, we are not seeing a recession. We now have to see whether the banking turbulence changes anything in that regard. So far, there are no particular signs of a weakening in economic developments. At this point in time, I have no reason to believe that a recession is coming.

Are you confident that the worst of the financial market tensions is behind us – even if the ECB keeps raising interest rates?

Let me say first that we’ve seen certain individual banking problems, and typically such problems are related to idiosyncratic causes due to poor business strategies. But we have to be aware of the fact that we are currently seeing a fundamental change in the macroeconomic environment. We are coming out of a very long period with very low interest rates. That was a period in which a number of financial fragilities were built up, which are now exposed by the rapid hiking cycle. Rising interest rates affect funding costs and asset prices, and they affect everybody at the same time, banks and non-banks. This poses challenges we need to take very seriously.

What is key is financial regulation and supervision. They have to make sure that the financial sector is sound. If I look at the euro area banking sector, it appears quite resilient. Capital and liquidity ratios are high thanks to the reforms that have been implemented after the global financial crisis. It could be that risks are lurking in the non-bank sector, which has had fewer regulatory changes. Some investment funds, for example, are strongly leveraged. Many have engaged in massive maturity transformation. And investment funds are affected by the structural changes that we are seeing, for example, in commercial real estate where they are very active in the euro area. Due to the interconnections between banks and non-banks, these risks need to be monitored very carefully. That’s mainly a task for regulators and supervisors.

However, we said very clearly in our monetary policy strategy review that financial stability is a precondition for price stability, and vice versa. So, we cannot entirely ignore financial stability considerations. At the same time, it has to be clear that monetary policymakers have tools to deal with impairments to the monetary policy transmission mechanism and with liquidity crises, but we do not have the tools to ensure a safe and sound financial sector. That has to be done by the regulators and by the supervisors. We cannot succumb to financial dominance.

Can you see a situation where you would slow interest rate hikes because of concerns over the banking sector?

If we were getting close to an acute financial crisis, then of course we could not ignore it. Financial crises are disinflationary. That we know very well.

I would like to talk about quantitative tightening. There’s going to be a decision in June about the speed of unwinding your APP bond holdings. Do you think the ECB should significantly speed up the process or even halt reinvestments altogether after June?

At the moment, we are reducing our APP holdings on average by €15 billion per month. And what we’ve seen is that the market absorption has gone very smoothly. This is good news. We have not seen any abrupt price changes nor any financial disturbances. The goal is to completely phase out reinvestments under the APP, and the precise timing is going to be decided soon. We continue to be predictable. The phasing out has been well telegraphed to the markets. There is no surprise there. The amounts involved are relatively small.

What about PEPP? Can you envisage a scenario under which you would reduce reinvestments earlier than the currently foreseen end-2024?

We have not yet discussed whether there could be a change. So far, the guidance is full reinvestment until the end of 2024.

Why do you need to reduce bond holdings if this is seen as secondary to achieving your inflation target and the current outlook so uncertain?

I do think that reducing the balance sheet has to be part of our tightening strategy. How far that goes is an open question. We’re currently reviewing our operational framework for monetary policy implementation. The outcome of that review is going to determine where we’re going to end up. It’s very hard to say where the precise endpoint is, but the choice of an operational framework has implications for whether we will have a very large or a smaller balance sheet in the steady state. It’s well conceivable that in the steady state we will continue to have a structural bond portfolio, but that it is going to be much smaller than what we have now.

When will you come to a decision about what your operational framework is going to look like in future?

The goal is to finalise the review by the end of this year. We will have to see whether that will work out, but that’s the current plan. Work has been going on for a couple of months. It’s a Eurosystem effort.

How would you respond to criticism that the ECB is not sufficiently transparent about how it applies flexibility in PEPP reinvestments?

We are quite transparent about our reinvestment policies. The general principle is that reinvestments are conducted in the asset class and the jurisdiction where the bonds fall due. But in June last year, we announced that under the PEPP, we would be willing to reinvest flexibly across time, asset classes and jurisdictions in order to preserve the functioning of the monetary policy transmission mechanism under stressed conditions.

We publish the PEPP purchases across jurisdictions every two months. There you can see that the actual use of this flexibility was rather limited. So, the power of this tool comes from the fact that we stand ready to use it, not that we are necessarily using it. I think that is a very important point.

But let me stress one other point for interpreting the numbers that are published. Temporary deviations from the capital key can also be due to a more technical feature, which is what we call the smoothing mechanism. We smooth out the purchases over the entire calendar year in order to ensure an even market presence over time. All of this is explained in detail on our website.

So, you would argue that suggestions that the ECB conducted QT for Germany and the Netherlands and QE for Italy and Spain this year are inaccurate?

Yes, that’s a wrong characterisation. Whether or not flexibility is used, you will find out at the end of the calendar year when these temporary deviations from the smoothing mechanism will have been balanced out.

The ECB is turning 25. What are your birthday wishes for the institution?

My birthday wishes are that the political leaders manage to make further progress on European integration including on the fiscal side, the banking union and the capital markets union in order to fully reap the benefits of the single monetary policy in a heterogeneous currency union.

When you say on the fiscal side, what do you mean specifically? Do you mean a permanent fiscal capacity?

One of the currently discussed topics is the Stability and Growth Pact. This is very important for the ECB. A functioning fiscal framework shields us from fiscal dominance and protects our independence. The ECB has a keen interest in a credible fiscal framework that ensures debt sustainability in a way that is growth-friendly, not procyclical and enforceable. That is very important to us.

Beyond that, we need to start thinking about permanent common fiscal tools, because the currency union currently has a single monetary policy and national fiscal policies. So far, we have had good experience with the Next Generation EU programme. That was a very important step.

Of course, that was a one-off tool. But we may need to think about going a step further, taking into account all of the valid concerns that exist about diluting incentives for fiscal discipline by debt mutualisation. This would have to be taken into account properly in the design of such a facility. But I think it still has to be the longer-term vision that we move towards a system where there are also fiscal tools at the European level.

You said that the experience with the Next Generation EU had been positive. So, has that addressed these concerns sufficiently?

I think one of the major strengths of the Next Generation EU programme is that it takes a structural perspective and that it’s focused on fostering potential growth and hence also convergence in the euro area, which would be great progress.

Turning back to the Stability and Growth Pact, what is your view on the current reform proposal? Do they meet your three criteria of being growth friendly, not procyclical and enforceable?

This is very much in flux and I’m not the one who should comment in detail on these political proposals. But maybe the biggest weakness of the proposal is on the enforceability side and that needs to be discussed.