Q: We’ve seen two weeks of turmoil for banks. What are the lessons so far?
A: I think it's too early to talk about lessons but there are a few issues worth considering. For instance, that interest rate risk in the banking book deserves a more prominent treatment and a more prominent discussion among banking supervisors. That’s one of the lessons we can learn from the series of banking issues among the regional banks in the United States. Credit Suisse is still quite fresh. It looks like an idiosyncratic failure due to governance issues, outright scandals and poor investments. I find it very hard to already draw lessons from that. Obviously, the dust has not yet settled on the issue of additional tier 1 (AT1) capital versus equity. To me, it's not yet entirely clear why the Swiss authorities decided what they did. But clearly, it will have ramifications for the AT1 market and for those banks that were intending to issue in the AT1 market in the coming weeks or months.
For monetary policy, a big question is how permanent or temporary the current turmoil is going to be. Financial conditions are a combination of the risk free curve, which we try to impact with our policy decisions, plus a wide set of risk premia, which are now clearly affected by the market turmoil. The question is how large and how long lasting the impact of the turmoil is going to be.
Q: What are the risks for the euro zone from this banking crisis?
A: At the moment, I don't see any real contagion channels. I have no evidence that the vulnerabilities we saw in the U.S and Switzerland are also present in the European banking sector. We manage interest rate risk in the banking book in a more stringent fashion than US regulators tended to do for the second tier of their banking system. We have a fully-fledged Pillar 2 treatment of interest rate risk. As a result, European banks would not be allowed to take interest rate risks like SVB did. The SSM also performed a targeted review, doing a very specific investigation into the management of interest rate risk in the banking book as recently as last fall. I'm also not aware of any bank in the euro zone that currently has the set of incidents that Credit Suisse was affected by. So, I'm quite confident that the European banking sector is in a much better shape. But if there continues to be more general risk aversion in financial markets, and this is going to have an impact on the global economy, then of course that might also have a downward impact on the euro area economy through real-economy channels.
For now though, our economy is actually still gaining momentum. High frequency data is showing improvement and confidence indicators are rising.
Q: Banks are not taking up ECB liquidity, yet turbulence
persists, and share prices are down. What can the ECB do to
help?
A: Keep in mind that the share price of a bank has no impact
on its liquidity or solvency position. If we believe that there
is no solvency issue -- because banks are much better
capitalized than they were 10 to 15 years ago – and there is no
liquidity issue at all, then what could be left for us to do?
Share prices have come down. But they went up massively at the
beginning of the year and the levels we are currently seeing are
not very worrisome. Shares are still up relative to where they
were only a few months ago.
Q: Have you seen any large scale deposit movements within the euro zone bank sector? A: No. And we've explicitly taken stock of that when we met last week. Deposits are stable and for the right reasons.
Q: Did the Governing Council meet over the weekend to discuss Credit Suisse? A: We had a virtual meeting late evening on Sunday. We received a debrief on Credit Suisse from the ECB as they had been in touch with Swiss authorities.
Q: Were AT1s part of that discussion?
A: Yes, and we reconfirmed that we do not intend to mimic the Swiss example in the euro area and that is also ingrained into our resolution regime.
Q: What indicators would tell you that turmoil is spreading
in the bank sector?
A: I usually look at spreads, CDS pricing, and market
pricing of risk premia in the broadest sense of the word. We
know that there is significant indebtedness everywhere in the
economy. It's not only about public debt but clearly about
private sector debt as well, like corporate debt and mortgages.
This is the fallout from years and years of low interest rates,
when borrowing was essentially free.
At the same time, many of the obligors extended the maturity
over which they borrowed. In the Netherlands, for instance, the
average mortgage debt has a fixed interest rate for over 16
years. So, the impact of higher interest rates, which is
definitely going to be felt everywhere in the economy, will come
with a certain delay. The same is true for many of the of the
sovereigns that have increased their borrowing, as they have
also managed to extend the duration of their borrowing.
So, I look at market indicators and I look at debt burdens to see what adjustment in the primary fiscal balance will be needed to compensate for the increase in sovereign interest burdens.
Q: Prior to the market turmoil, you said significant rate hikes are still needed. How do you see rate outlook now?
A: I think there's even more uncertainty now than before. This turmoil is a downside risk to inflation, and it will also lead to higher funding costs for those banks that have plans to issue AT1 securities in the coming weeks or months. This will likely affect their lending.
But for all this to materially affect our inflation baseline, the turmoil will need to have a strong, permanent character. We now enjoy the luxury of having quite some time before our next policy meeting, so that we can come to a better assessment then. Undoubtedly there is a risk that the turmoil will have an additional downward impact on the availability of credit supply. But again, for this channel to materially affect the inflation outlook, a lot will still need to happen.
Q: So, you need a significant permanent impact to affect rate policy? A: Yes. Because absent of this factor, risks – in my view – are clearly still tilted to the upside when it comes to inflation. Take our baseline projections. These already included significantly more additional tightening as the baseline used market pricing at the cut-off date, when terminal rates were moving toward 4%. So, for the baseline, we would need significant additional tightening compared to current market conditions.
You could of course say that the baseline is no longer the baseline because the turmoil wasn’t included in the calculations. But without this turmoil, there are significant upside risks to inflation and inflation persistence because underlying inflation continues to surprise us and the second-round effects of wages are now clearly visible. The big question is how far this gradual increase in wages will go and where will it stop. Workers are increasingly focused on making up for lost purchasing power. It seems that in wage negotiations, they are more preoccupied with the past than with the future. So, there I still see some catch-up risks from wages, too. On the other hand, the turmoil might lead to some additional tightening of financing conditions not triggered by monetary policy, in which case maybe we have to do less. So, I think Philip Lane laid out our reaction function quite nicely and this is also clear in our communication. There are three issues we need to focus on: How the inflation outlook evolves, how persistent underlying inflation pressures prove to be and how forceful the transmission of monetary policy actions we have already taken, will be. On top of this, we now will have an additional impetus from the financial turmoil that may impact credit availability.
Q: Based on this significant permanent impact, you continue to expect rates to increase? A: Yes, I regard it unlikely that we would already be done by now. That scenario is unlikely. But the turmoil clearly gives rise to a potential revaluation of the amount of ground that we still have to cover.
Q: What did you think when markets earlier this week priced no more rate hikes but saw some cuts?
A: I think market pricing is now very much dominated by the elevated uncertainty but as uncertainty recedes, I expect some of the recent decline in market pricing to reverse. Our inflation problem will not entirely be resolved by this market turbulence.
Q: The ECB has signalled that once rates peak, they should stay there for some time. But what does “some time” mean?
A: We’ll cross that bridge when we come to it. There is a lot of empirical evidence that wage and price setting in the euro area is rather sticky. We continue to be surprised by the persistence of underlying inflation trends. So, it’s an illusion to think that we reach peak inflation at some point during the year and very quickly thereafter cut rates again. I've always been watching this expectation with some bewilderment. But we are still in tightening mode. Let's first do the tightening, then we’ll see for how long we will have to stay there.
Q: You have argued in the past that the wind down of the APP portfolio should be accelerated. What is your view now? A: Interest rates are in positive territory again and that has attracted a lot of renewed interest from foreign investors in European sovereign risk. So, the reduction in our APP reinvestments has been smooth so far. Luckily, we have set out a course until the end of June, so I don't think we have to take a decision now. It was not even discussed last week and I don’t think we will come to that decision in May either. So, let's keep our powder dry until that decision. But I continue to be of the opinion that the size of our balance sheet is simply inconsistent with the inflation outlook and there is still too much excess liquidity in the system. So, this should be an integral part of the tightening of monetary conditions that we aim for.
We will proceed cautiously here. If there is no additional turmoil in the coming weeks, then I think that we can gradually move toward a full stop of APP reinvestments under the condition that it can be accomplished without creating undue turbulence in the euro area bond markets. Q: The ECB is now taking financial stability considerations into account in policy decisions. But are you confident that price and financial stability needs won’t clash? A: As long as the financial turmoil is limited, the only spillover is that it leads to some additional tightening of credit conditions. But let's not overemphasize the significance of this. In this case, we can uphold the separation principle and continue to use the interest rate as the primary instrument to reach our inflation target. For liquidity stress, we have different instruments at our disposal.
If the turmoil were not to subside, which is not my baseline scenario, then at some point it will have a material impact also on the inflation outlook because we know that financial crises are deflationary. But let me reiterate, we are very, very far away from a situation that I would describe as a financial crisis.
Of course, we’ve seen a couple of bank failures and investors have a collective memory of 2008/2009, so the market is assigning a nonzero probability to a financial crisis scenario. I think it's overdone, but that scenario is now also in market pricing.
But this uncertainty might actually also recede quite fast and a lot of this market pricing might then reverse. Q: If these ‘what if’ scenarios materialise, what are your preferred tools, from ELA to TLTROs and OMT?
A: That's of course the whole spectrum. If we're talking about stress in the banking system for the moment, refinancing operations are the natural tool. But at the moment, banks are repaying their TLTROs. So, I don't think we are in any way near this, but if necessary we could set up an LTRO relatively rapidly.
Q: Are the existing tools enough?
A: I’m pretty confident in our existing tools plus our creativity to design new tools when needed. We have demonstrated many, many times in the past that we can deal with any emerging liquidity stress in the banking sector.
Q: Are interest rates already in restrictive territory? A: I would say they're in mildly restrictive territory but let us not forget that we have a stubborn inflation issue in core inflation. Latest readings still show strong upward momentum. So, under normal circumstances, I would not think that interest rates in this mildly restrictive domain would be enough to generate the immaculate disinflation that we probably all hope for.
I think the U.S. and U.K. experiences already show that disinflation may well turn out to be a very bumpy process. Headline inflation in the euro area is projected to fall steeply because of base effects. But I've always said that when there is a big swing in headline inflation, we have to look through that and focus on underlying inflation.
Now that headline inflation is coming down, we should not let ourselves be lulled into comfort. Our real inflation problem is core, which shows no sign of abating yet. And because of that, it’s highly questionable whether maintaining rates only in mildly restrictive territory will be enough to bring inflation back to target over the medium term.
Q: Do you expect core to accelerate still?
A: It’s difficult to tell. There are a lot of dynamics in core inflation that we have not understood well in the past. It continued to rise and surprise on the upside in February. There is still a lot of demand in the economy. We have had discussions on profit margins being one of the sources of inflation. But firms would not be able to increase their profit margins if there was not a robust demand. So, demand is still very strong. Part of the rise in core has been the delayed effect of energy inflation. But historical evidence doesn’t suggest that this is a symmetric process in the sense that you can also expect core inflation to mechanically come down once energy inflation comes down. On the way up energy inflation has clearly been a big driver of the rise in core inflation. But in the meantime, the drivers have changed. It's more domestic now. It's about wages, it’s about demand for services driving core inflation. We also know that wage and price formation in the euro area is stickier, more rigid than in the U.S., which is all the more reason to remain a bit cautious.
I will need to see evidence of pipeline pressures receding, and pipeline pressures are giving mixed signals at this moment. They're not unambiguously signalling upwards anymore, as used to be the case a few months ago. So, in that sense, there is a small positive here, but I clearly will need to see more of this.
Q: How much of a problem are wages? Real wages are still falling so they’re not even catching up, yet 5-6% wage growth is inconsistent with your inflation target. A: Your second point is true regardless of the circumstances. If you have a 2% inflation target, and you have productivity growth somewhere between a 0.5% and 1%, then the maximum wage growth you can have that is consistent with your inflation target is 3%.
At this moment wage growth is still below inflation. But this may no longer be true in the second half of this year because headline inflation is going to decline rapidly. And that's good news for our citizens, by the way. It's good news, that at least the loss in purchasing power of our citizens seems to be coming to a halt. But if wages continue to be backward looking, then we may well be in a situation where in the second half of this year, your first point is no longer true and wage growth will run at a higher pace than inflation.
Q: How do you change workers’ thinking and get them to look to future inflation rather than past?
A: The good news is that we have staggered wage formation and in most of the multi-year wage contracts that I've seen, there is a lower percentage in there for 2024.That also tells me that there is still credibility of the ECBs anti-inflation credentials, even though on balance, the numbers are still too high. At least there is a declining pattern in those wage contracts that span multiple years. So, I see no wage price spiral and rather see wage price dynamics which are gradually extinguishing. Is that all going to take place within the next 12 to 24 months? I'm not sure about that.
Q: How will tight labour markets affect wages and core
inflation?
A: There is already quite a bit of wage growth in our
projections, roughly 5% in both 2023 and 2024. But I do think
that the impressively resilient labour market continues to
provide for an upside risk. I think most of the remaining
unemployment that we have in the euro area is actually mismatch
in unemployment. That is not cyclical unemployment. So, the
labour market is tight everywhere.
(Reporting by Balazs Koranyi)
