ECB Chief Economist: Decisions to be based on inflation, interest rates (video)

The next monetary policy decisions on European Central Bank’s interest rates will be based on the incoming data, Philip Lane, chief economist and member of the ECB’s executive board has said in an interview with the CNA.

Lane, who visiting Cyprus following an invitation of the Governor of the Central Bank of Cyprus and ECB board member Constantinos Herodotou, said that Euro area banks are under strict supervision by the ECB and have high capital and liquidity ratios to face possible challenges emerging from rate hikes.

Following its last interest rate hike, its sixth hike since last July, the ECB, according to Lane, will assess all incoming data both regarding inflation as well as possible effects emerging from the shocks caused by the failures of regional banks in the US and Credit Suisse.

“I think we were clear in our March meeting and we made a further increase then. A lot has been done, but we have also been clear that our next decision in May will depend on three factors,” he said.

The Irish ECB chief economist said that decisions will depend on the inflation outlook, as the ECB has information coming every week, the underlying dynamic, not just the overall inflation rate, but their assessment of how quickly inflation is going to fall and whether inflation was going to remain too high for too long. The third factor, he added, is how quickly these interest rate increases are restricting the economy and bringing down inflation.

“So for these reasons we have no longer indicated or pre-announced what the expectation is for the next meeting or for the upcoming meetings. I think we will be looking very carefully at all of these data in the coming weeks,” Lane stressed.

Understanding every data point

Responding to a question, Lane said the focus should be on understanding every data point that comes in.

“Are we seeing signs that inflation is cooling? Are we seeing signs that interest rate increases are reducing credit, for example? Are they leading to lower investment, lower consumption, lower pressure on the economy and, therefore, lower inflation? We still have quite a long way to go between now and the May meeting, which is about a month away,” he said, pointing out that rather than trying to predict now what the decision will be, our attention will be on the incoming data. We will analyse these until the day of the meeting and make a decision then, he added.

Replying to a question on the overall direction of the ECB, Lane said in March we had a set of macro projections for the coming months.

“If, by the time of the May meeting, those projections remain on track, then a rate hike will be appropriate,” he said, noting however, that “we need to be scientific and data-dependent, so in these weeks we have to see whether the incoming data support that projection from March.”

If they create more inflation concerns, that will move us in one direction; if they create less inflation concerns, that will move us in another direction. So I think the formula would be: if the baseline we developed before the banking stress holds up, it will be appropriate to have a further increase in May,” the ECB chief economist said.

OPEC's decision to cut oil production

Asked whether the OPEC decision to cut oil production perplexes the ECB monetary policy stance, Lane said this should be assessed in the context of the in the context of a fairly large drop in recent months, noting that “the overall price of energy – the mix between oil, gas and electricity – is, of course, a big part of the inflation dynamic.”

“This is some reversal of that trend, but in the context of a fairly negative trend, we’ve seen a very large ongoing reduction in gas prices, and the reduction in pressure from energy reduces the pressure on the rest of the economy,” Lane went on to say, noting “it’s not only about the mechanical effect of energy prices – one of the biggest issues for us is how the rest of the economy responds to the energy dynamic.”

He recalled that following the rise in utility bills which added pressure on many sectors in 2022, “this year, with gas really improving quite a bit and with oil declining until quite recently, this will also relieve pressure on many sectors. So, this is why it is really quite uncertain.”

“This is why the data inflow is so important, because it’s possible to debate many possibilities, and we really have to see, in an overall context, the net impact of these dynamics,” Lane said.

Responding to criticism

Replying to a comment that many in Cyprus criticise the ECB for consecutive rate hikes irrespective of the effects on the real economy and on borrowers’ ability to repay their loans, Lane said the ECB works “very hard to try to make balanced decisions” and fully take into account the impact of these interest rate increases on those who have debt, who face a bigger repayment challenge, and the implications for investment and for households.

“But please remember, the reason why we are raising interest rates now is because inflation is high. In order to make sure that inflation comes back to a low number, to around our 2% target, we do think it’s necessary, it’s unavoidable, to make these interest rate increases,” he said.

“If we did not do this, if we kept rates too low,” he went on, “we think inflation would remain too high for too long, and this would not serve anyone. It would mean, in fact, a tougher economic situation for a longer period of time.”

According to Lane, raising rates now “is the best route to stability, is the best route to making sure the economy is in good shape, and that the cost of living stabilises.”

“Of course it’s difficult for those who were hoping for low interest rates, but this is an important episode. It’s important for us at the ECB to make sure that the interest rate policy responds to the inflation challenge. And for those who are expressing these concerns, I’m sure they share my conviction that all of us need to see inflation come back down to a low number, around 2%, as soon as possible” he said.

He also pointed out that those who suffer most from high inflation are those on low incomes, who right now are facing very high food prices and still absorbing the increase in electricity and gas prices last year.

“It’s in everyone’s interest not to allow inflation to remain too high for too long,” Lane stated.

Overseas banking turmoil

Furthermore, replying to a question on the failures of regional banks in the US and the turmoil associated with Credit Suisse, Lane said it is important for everyone to understand the differences between the euro area, Switzerland and the US banking system.

“In the euro area we’ve had a very significant focus on making sure that the banks have high capital and liquidity ratios, that they are supervised in a strict way by the European Central Bank. For these reasons and also because we see that the European economy is performing relatively well and is expected to grow by around 1% this year, of course, we look carefully, but our assessment is that the euro area banking system is strong, it’s stable, and it is not as vulnerable as some of the banks you mentioned to changes in interest rates, to changes in the economy.”

“So while we are always on guard, I think that everyone should understand the euro area banking system is in good shape,” he added.

Asked whether there are any similarities between the US and the Euro area banks, Lane reiterated that at the ECB they are always looking closely and with great attention, adding that “because of the strict supervision, because European supervisors were on guard about the implications of rising interest rates for banks, it’s becoming increasingly clear that investors appreciate that the European banking system has prepared for the situation we face of rising interest rates, and that these risks are well contained.”

“For this reason we should be confident about the state of the European banking system,” he said.

Rate hike risk is well understood

Asked on potential losses on the banks’ fixed-income portfolios due to rate hikes, Lane replied that this this is one of the risks that is well understood and is exactly why it’s important to pay attention that the size of the bond portfolio that a bank holds is not too big, that it’s properly accounted for, it’s properly managed, and that the banks have enough capital to guard against any loss in value of these bonds.

“What I would say is, from the European Central Bank’s point of view, we have taken a step-by-step approach to monetary tightening since around the end of 2021 to now. There has been a significant increase in interest rates, but it’s been gradual, it’s been step-by-step, and that has given the European system time to adjust to this change in the situation,” he said.

Replying to a comment that economists have pointed out that the EU should reconsider implementing the European deposit insurance scheme (EDIS), thereby completing the banking union, Lane said we all share a common vision, that where we want to end up is at the full banking union, which includes EDIS, a European deposit insurance scheme.

“But I think,” he said, “everyone should recognise that to arrive at that destination it’s a step-by-step process. It’s important that there is momentum, that all of the prerequisites, all of the necessary steps, need to be delivered.”

Recalling that this was a matter of discussion in the last number of years, Lane highlighted that “what we’ve seen this year reinforces the value, not only of a full banking union, but also a full capital markets union in Europe.”

Lane concluded by saying that “we share that vision, absolutely, but it’s not a one-day decision, it’s not an overnight decision; a lot of different elements need to be delivered for that to be achieved.”

(Source: CNA)