Interview with Bloomberg

Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Mark Schrörs and Alexander Weber on 25 November 2024

27 November 2024

Euro area business activity slipped deep into contractionary territory in November, according to the S&P Purchasing Managers’ Index (PMI). Is a soft landing becoming less likely and is the risk of stagnation or even recession increasing?

I wasn’t all that surprised by the PMI data, given all the uncertainty we’re facing with the US elections and political issues in some of the larger euro area countries. In combination with hard data, the surveys suggest that the euro area economy is still stagnating. It’s facing a combination of cyclical and structural weaknesses in a very volatile and uncertain global environment. On the cyclical side, we continue to expect a consumption-driven recovery helped by rising real incomes and falling interest rates. But we’re also facing structural headwinds, and that could mean that investment remains sluggish even as interest rates decline.

After the manufacturing sector, the service sector has now fallen into contractionary territory too. Are you alarmed about that? Does it indicate perhaps a more sustained downturn or weakening?

The surveys haven’t always been very reliable indicators recently, they have been a bit weaker than the hard data. So before drawing any strong conclusions about the services sector, I would wait for the hard data.

But you don’t see a recession looming at the moment? 

I don’t see a risk of a recession at the moment.

What about the labour market? It held up well for a long time, but now there’s a lot of anecdotal evidence of job losses, especially in Germany, and unemployment rates are inching up. 

We’ve seen some heterogeneity across the euro area in terms of growth, and this heterogeneity is also showing up in the labour market. If you look at the aggregate numbers, employment growth is still holding up and the unemployment rate is very low. But in parts of the euro area, we’re starting to see a softening of the labour market and we need to monitor that going forward.

Do you see a risk of a more sudden deterioration?

So far I don’t see any indication of that, but we must watch that carefully.

You mentioned that the expectation is still for a consumption-led recovery. Have you become more optimistic about consumption recently?

Consumption in the third quarter, as far as we can tell on the basis of the available data, was stronger than expected. We see some evidence of a consumption-driven recovery in the data. This gives me confidence that this narrative remains plausible.

How does the return of Donald Trump to the White House affect the euro area economy, in particular given his plans for trade tariffs?

We have very little information at this point, so we cannot make an assessment at this point. We need to watch how this is going to play out. That being said, we’re already seeing some changes in financial markets. Investors expect a stronger US economy and a somewhat weaker euro area economy, which has led to a divergence in the expected monetary policy paths in the United States and the euro area and also to a depreciation of the euro exchange rate against the US dollar.

In general, tariffs would pose some downside risks to economic growth in the euro area. On the inflation side, it’s more complicated. On the one hand, tariffs could be inflationary, in particular if there’s retaliation. Then we would have rising import prices, reinforced by a weaker exchange rate. On the other hand, you could have weaker foreign and domestic demand and a diversion of trade from China to the euro area, which could dampen price pressures. Overall, if we look at what happened during the globalisation phase, it was net disinflationary. So I would expect that a partial reversal of this process should on net have an inflationary effect. But that remains to be seen and the precise impact will also depend on how the measures are designed in the end.

But on the growth side, don’t you think that uncertainty alone will already have an impact irrespective of what will be decided later on?

Uncertainty is certainly a key part of the story. We know that uncertainty has an impact on consumption and investment.

Another large uncertainty at the moment is the situation in Germany. How worried are you about the weakness of the German economy, which is also structural, and the implications for the euro area?

Germany is particularly exposed to recent shocks because it is very export-oriented. It has a high share of manufacturing, and it also had a very high dependence on Russian gas. But the structural problems go beyond Germany, and this is why Europe as a whole needs to rethink its business model.

Would it make sense for the new German government to make more use of the fiscal space, given low debt levels and a balanced budget?

I don’t comment on country-specific developments. We’ve seen in the report by Mario Draghi that Europe has a very high investment need, and part of that is public investment, even if the largest part is private investment. If a country has fiscal space, it may not be a bad idea to use it to foster public investment.

The PMI data was particularly bad in France, which also has a fiscal problem. Do you think that the picture in France is perhaps even more worrisome than in Germany?

Again, I don’t comment on individual countries, but of course the fiscal aspect is quite relevant. We have a number of countries with very high debt-to-GDP ratios and high public deficits. There’s a clear need for some consolidation in line with the new European fiscal framework. But it’s important to strike a balance between consolidation and the prioritisation of public investment. The new fiscal rules provide space to make sure that there’s room for public investment.

But is the focus still on fiscal consolidation or does the weak economy mean that there is a need to look more at what governments can do to support the economy?

The most important task for governments is structural reforms. It’s not about discretionary fiscal spending. We have received many excellent suggestions about what can be done, and it’s high time to follow up on those.

Services inflation is still hovering around 4%. Is this still mostly due to catch-up effects in wages or is there also a structural component due to labour shortages?

Services inflation is still elevated. It’s standing at 4%, the same number as in November of last year. For a sustainable decline of inflation to our 2% target, we need to see services inflation come down. This will require a deceleration in wage growth, which is still strong. A large part of that is likely due to catch-up effects. If I look at our surveys, we can expect a deceleration in wage growth, and the most recent wage negotiations, for example in Germany, were not very strong. This gives me some confidence that wage growth is going to decline in line with our projections.

To what level must services inflation fall to be compatible with the 2% inflation target? Would 3% be low enough?

There is no specific number because we must look at the overall picture. There could be new shocks in other inflation components. We’ve seen, for example, that gas prices have gone up notably. Food prices have picked up again recently, too. But overall, the disinflationary process is on track. I expect that inflation is going to return sustainably to our 2% target over the course of 2025.

And what does that mean? The first half of 2025?

There’s an exaggerated focus on the precise timing. Economically, it doesn’t matter if it’s the second, the third or the fourth quarter. So we should stay away from fine-tuning. And inflation could also continue to fluctuate. There was a bumpy road this year, and there could also be a bumpy road next year. We shouldn’t pay too much attention to every single bump in either direction.

The ECB Governing Council hasn’t been giving a risk balance for inflation for a while, but do you dare to say whether the risks to inflation are to the upside, to the downside or in balance?

Risks to inflation are now more balanced. But I don’t see a significant risk of an undershoot, in particular one that would warrant a response from our side.

But some of your colleagues are afraid of that kind of scenario. What makes you confident that this risk of undershooting is low?

We need to wait for the new Eurosystem staff macroeconomic projections. My expectation is that projected inflation will remain close to our target over the medium term, and that would be an indication that we’re on track. And if you look at the recent PMIs, there’s also information on prices and you get the impression that the high prices are still working their way through the economy and that if anything price pressures still remain elevated.

At which point would you see a need to react to too low inflation?

Part of the weakness we’re seeing is structural. If firms don’t invest for reasons other than monetary policy, lowering interest rates below neutral may not bring investment up. You need structural policies to achieve that. In such a situation, the costs of moving into accommodative territory could be higher than the benefits. The measures wouldn’t be very effective. At the same time, we would use valuable policy space that will be needed in the future when the economy is facing shocks that monetary policy can deal with more effectively. We have to understand where the weakness of the economy is coming from to see how monetary policy should respond. If an undershooting is mainly caused by structural factors, I would be reluctant to respond too strongly.

Another cut in December appears very likely. What needs to happen for you not to cut at the next policy meeting?

I’m not going to comment on the next monetary policy meeting. But given the inflation outlook, I think we can gradually move towards neutral if the incoming data continue to confirm our baseline. I would like to stress the word gradual, for three reasons. One is the still elevated services inflation, so an important part of the disinflation still needs to materialise. The second is that we need to be mindful of new shocks. I mentioned gas and food prices. And the third is that we’re now getting closer to neutral territory. Of course, nobody knows where the neutral rate is. We have many different model estimates, each of which is surrounded by huge uncertainty.

But when I look at the data, it seems to me that the restrictive impact of our past monetary policy tightening is fading visibly. We see that real interest rates are now close to zero across maturities. This is very low from a historical perspective. We also see in our most recent euro area bank lending survey that almost all banks report that loan demand is no longer affected by the general level of interest rates. That’s very different from a year ago when nearly half of euro area banks reported that interest rates weighed on loan demand. Moreover, the housing market, which tends to be the most interest rate sensitive, seems to be bottoming out. We’ve also seen an increase in the demand for mortgages.

All of that is telling me that we may not be so far from the neutral rate, which I would put into a range between 2% and 3%. That’s a bit higher than it used to be before the pandemic, but we’re also in a very different world. We have much higher public debt, more fragmentation and significant investment needs to tackle the challenges we are facing. And we also have a potential productivity boost from the AI revolution.

The plausible range is of course still relatively large, which means we need to remain data-dependent. Given all the uncertainty we are facing, this is not the time for tying our hands through forward guidance. How can I communicate about our destination if I don’t know it myself? We need to look at the data in order to see how restrictive we still are. And I would warn against moving too far, that is into accommodative territory. I don’t think that would be appropriate from today’s perspective.

Some of your colleagues have discussed the possibility of cutting rates by 50 basis points. Given all you just said, would you rule that out?

I never rule anything out, but I have a strong preference for a gradual approach.

Is the meeting-by-meeting approach still appropriate?

For me, yes, certainly. Even if you know the direction, it’s difficult to commit if you don’t know the destination. And that issue is becoming more important. I don’t want to feel bound by previous communication, I want to be able to adjust policy at every single meeting.

Markets are already pricing in rates below your estimate of neutral, around 1.75%, and some economists even talk about 1% around the end of next year. Doesn’t this go against your view?

Markets seem to assume that we will need to move into accommodative territory. From today’s perspective, I do not think that would be appropriate.

Some analysts also said that rates have to fall further as a result of the US election. Do you agree with this view?

No, I don’t agree. The main impact of the election is probably on growth, while on inflation, it’s much less clear. In fact, inflation could even move up, and our primary objective is price stability. We consider economic growth only insofar as it has an impact on inflation. In this particular case, I think the impact of tariffs on inflation is, if anything, slightly positive. This cannot justify an accommodative policy stance.

If there are fewer cuts by the Federal Reserve, does this limit your ability to reduce rates?

I wouldn’t say so. We set our own monetary policy based on our analysis of the euro area. Of course, what happens in the United States has an impact on our projections. There may be spillovers in financial markets and there could be adjustments of the exchange rate, and all of that is going to be taken into account. But we have to do what is necessary in order to preserve price stability in the euro area.

Is a scenario in which the euro falls back to parity with the dollar something that worries you given the inflation implications?

A material depreciation of the exchange rate will have an impact on inflation, but that doesn’t have any direct policy implication beyond that. We are not targeting any specific exchange rate and we’ve had an exchange rate at parity before. We need to see how the overall picture on the inflation outlook is developing.

The projections in December will have a new number for inflation and growth in 2027. Will you draw any conclusions from that, for example if the forecast for price growth falls further below the 2% level?

We know that the longer the horizon, the less reliable the projections. So I would treat these numbers with caution. For my own decision, they don’t matter much. There are many things that can happen until then. Today’s policy decision should not depend on the 2027 number.

You’ve been sceptical about using quantitative easing (QE) in the future. If at some point inflation were at 1.5% with interest rates already at the lower bound, would you prefer to live with 1.5% instead of resorting to QE?

When it comes to QE, we certainly have to look very carefully at the benefits and costs. With hindsight, I’m not entirely convinced how big the benefits really were. But I know that the costs have been high. So in the future, I would be more reluctant to go down that route. We should be more relaxed about moderate deviations of inflation from our target, in both directions.

In any case, a return to the pre-pandemic world with persistently low inflation seems unlikely. For example, there is a plan to expand the emissions trading system to further sectors. This in itself could already have a significant inflationary impact down the road. Whether that is really going to be implemented in 2027, I don’t know. But, in general, I see more shocks going in the inflationary direction, therefore I’m not seeing a return to the low inflation world.

Would you say that in the medium to longer term, inflation is going to be structurally higher?

The period before the pandemic was characterised by disinflationary supply-side shocks. It seems we are now entering a world that has more inflationary supply-side shocks. We’ve learned in recent years that it may not always be appropriate to look through such shocks because we have to make sure that we keep inflation expectations anchored. We are now coming out of a period of very high inflation, which means that everybody’s paying more attention to inflation. This could also mean that inflation expectations are more fragile in the sense that they’re more vulnerable to a de-anchoring. And this could imply that going forward, we will need to respond more forcefully to some adverse supply-side shocks.

There’ve been a few proposals on how to better communicate the economic forecasts, for example through dot plots or scenario analysis. Has your thinking evolved recently? Do you have a clearer idea what could be a good option?

There doesn’t seem to be a majority in favour of dot plots, even though I still think it’s an interesting instrument. Many people are in favour of putting more emphasis on scenario analysis. I’m not talking about scenario analysis regarding tail risks, but what I think we should do is move the focus away from a single baseline scenario with very precise numbers. This really gives an illusion of precision that isn’t there. Instead, we should have alternative, plausible scenarios in order to prepare for different courses of action – not just scenarios where the world is falling apart, but realistic alternative scenarios on what could happen to, for instance, wages or productivity. That would be a very good way to deal with the high uncertainty we’re facing.

There is this sentence in the strategy statement saying there is a need for persistent, forceful action if inflation is below 2%, but there is no corresponding view on what happens if inflation is above 2%. Do you see a need to change that?

Our previous monetary policy strategy was published at a time when we were mainly worried about inflation being too low. We are in a different world now and there is a possibility that we will face more inflationary shocks. Therefore, this strong asymmetry is no longer appropriate.