Interview with Nikkei

Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Shogo Akagawa and Takerou Minami on 13 May 2024

17 May 2024

The market sees a rate cut in June for sure. How fast should things move beyond June?

Depending on the incoming data and our new Eurosystem staff projections, a rate cut in June may be appropriate. But the path beyond June is much more uncertain. Recent data have confirmed that the last mile of disinflation is the most difficult. The disinflation process slowed down significantly after most of the supply-side shocks had been reversed and it's proving quite bumpy, and this appears to be a global phenomenon. In the euro area, part of this is due to base effects and to the reversal of fiscal measures. But more importantly, the part of inflation that has become entrenched through second-round effects is proving more persistent. Given the high uncertainty about the inflation outlook, we should give ourselves sufficient time to assess how the recovery is proceeding and how monetary policy affects economic growth and inflation.

Some of your colleagues mentioned a rate cut in July. What's your position on this?

Based on current data, a rate cut in July does not seem warranted. We should follow a cautious approach. After so many years of very high inflation and with inflation risks still being tilted to the upside, a front-loading of the easing process would come with a risk of easing prematurely. Further progress in inflation and especially domestic inflation, which is proving stickier, is needed to foster our confidence that inflation is going to sustainably return to our 2% target in 2025 at the latest.

But how should the ECB control the speed of interest rate moves beyond summer?

We are facing very high uncertainty, which has also been reflected in market expectations. We have moved from six rate cuts being priced in at the beginning of the year to around three rate cuts now. Due to this uncertainty, it is too early to say what is going to happen and we cannot pre-commit to any particular rate path. I like to think about this by means of scenarios. The first scenario is the one underlying our staff projections, in which wage growth is easing, productivity growth is recovering and firms are absorbing higher wage costs in their profit margins. In this case, the disinflation process remains on track, and we can gradually ease our level of restriction. In the second scenario, the data does not confirm an easing in wage growth, the assumed recovery in productivity, or the absorption of higher wage costs through profits, or there could be new supply-side shocks that disrupt the disinflationary process. In such a situation, we would need to be more careful, because it could mean that the return to our target is delayed or that inflation even picks up again. So, we need to see whether the incoming data confirm our baseline scenario. Our aim is to ensure that monetary policy succeeds in containing second-round effects.

To summarise, you want a slow pace, and to look very cautiously at the data beyond summer?

We should move cautiously. We should look very carefully at the data because there is a risk of easing prematurely. And we should give ourselves sufficient time to see what is happening.

Has the natural interest rate in the euro area risen compared to the pre-Corona period? Is the end point of the next rate cutting cycle around 2% or higher?

The current policy cycle is special in the sense that rate cuts are not meant to counter a looming recession, but rather to gradually withdraw restriction without reigniting inflation. This is quite challenging, because we need to take a stand on the level at which our interest rates may no longer be restrictive. Many people believe that the natural rate of interest has moved up and I share that view, especially given the exceptionally high investment needs arising globally from the green and digital transitions. But it's virtually impossible to quantify a change in the natural rate of interest in real time with any reasonable degree of precision. So, we will continue to look at the incoming data in order to assess how restrictive our monetary policy really is at each point in time. And the closer we get to a potentially neutral level, and this could be well above 2%, we need to move even more cautiously.

There's a lot of tension in the Middle East, even tension between Israel and Iran. What kind of impact could this situation have on the macro-economic development in Europe?

So far, the impact of the geopolitical shocks has been rather muted. However, a major escalation could impact oil prices, affect confidence or trigger new supply chain disruptions. Geopolitical shocks are a key risk that we need to watch, and this poses upside risks to the inflation outlook.

Over the longer run, geopolitical fragmentation would pose further upside risks to inflation by reducing the efficiency and reliability of global supply chains.

Geopolitical risk stems not only from authoritarian countries, but from democratic regions, too. In the next US election, we will be observing closely whether Donald Trump returns to the White House. Could this bring turmoil, or have an impact on the Eurozone economy?

Rising protectionism is a major risk. But the general trend towards more protectionism started already during the first Trump administration, and it has continued since then. This threatens global welfare. It harms open economies like the euro area that are committed to free trade. It also harms the less developed economies for which free trade offers the opportunity to move up the income ladder.

Could Germany, a pillar of the European economy, re-enter a period similar to that under Chancellor Schröder, as the ‘sick man of Europe’? Where do you see the European economy five years ahead?

The euro area is facing massive structural change. It's not just the price of energy, it's also the reliability of energy supply. We already discussed the geopolitical shifts. The euro area will need to think about a new and improved business model that is fit for this changed world. This period of structural change may give a push to focus on how to improve long-term growth and productivity and how to catch up on the technology side in order to remain competitive. The unexploited potential of the single market is huge.

There are big concerns that inflation will remain above 2%. Is an amendment of the ECB inflation target realistic?

The 2% target has served us well. A change in the target is not appropriate. Raising the target could damage the credibility of central banks, especially after such a long period of far too high inflation. Moreover, if it's true that the natural rate of interest may have moved up, the main argument for raising the inflation target, which is to increase the distance to the effective lower bound, is less pertinent.

Finally, recent experience has shown how big the costs of high inflation are, and this was felt widely throughout the economy. So, a change in the inflation target would likely meet strong opposition from the general public, which could also undermine the trust in our policies.

But what does a ‘2% target’ mean for you? Is there an acceptable range of figures?

We define the target as a symmetric target of 2% over the medium term. It is a number, not a range. Deviations to the upside are considered as harmful as deviations to the downside. This target of 2% is very important for anchoring inflation expectations. This is the number that people, such as wage setters, remember. It’s important that they have this number of 2% in mind, and not something fuzzy. This is very important for our communication.

Japan intervenes when the Yen slides against the Dollar. What is your position on market interventions? What's your view on the current exchange rate?

It's not up to me to comment on possible foreign exchange market interventions by Japanese authorities. And we don't comment on the level of exchange rates either.

The ECB may cut interest rates ahead of the Federal Reserve. It could affect the currency market, and a weaker euro may have an impact on prices and on the economy.

I wouldn’t overstate the narrative of monetary policy divergence. Since the beginning of the year, four rate cuts have been priced out for the US and three rate cuts for the euro area. The correlation of policy expectations across the two countries remains high in historical comparison. This has been reflected in rather contained exchange rate movements of the euro against the US dollar since the start of the year. Financial conditions have also remained broadly stable. So the last mile is a global phenomenon. We are seeing second-round effects all over the world and they are still working their way through our economies. Services inflation plays a large role in many jurisdictions. If you look at the euro area, two thirds of the April inflation were due to services inflation.

Another question is fiscal discipline. European governments are moving to allow more deficits. Does this policy make sense?

Fundamental structural changes, like the green and digital transitions and demographic change, are happening in a world that is becoming more polarised and less secure. Dealing with these challenges requires structural reforms and large private and public investments. At the same time, governments need to make sure that fiscal policies remain on a sustainable path, which is best achieved by a combination of growth policies and fiscal consolidation. This implies that urgently needed public investments need to be shielded from consolidation.

Are you concerned about the increase in defence spending in European countries?

There is no doubt that in the face of risks to our territorial security, it's necessary that governments in Europe spend more on defence. That is unavoidable. An important question is whether the spending on defence can be combined with a growth agenda. We have seen that in the past some of the big innovations have come from the area of defence. Of course, not all defence spending is productive, but it's nevertheless necessary, because our territorial security is a first order priority for Europe.