26 July 2024

Ms Schnabel, the ECB did not lower interest rates any further in July. Do the rising prices for services currently pose a problem for the central bank?

We continue to expect inflation to gradually converge to our 2% target over the course of next year. However, persistent services inflation shows that the “last mile” of the fight against inflation is particularly difficult.

Inflation now stands at 2.5% and the ECB’s target is 2%. Why should the last mile be difficult?

The first phase of the fight against inflation was relatively easy. Inflation in the euro area reached a peak of 10.6% in October 2022 before declining quickly to 2.4% in November 2023. This mainly reflected the reversal of earlier supply-side shocks. Energy prices fell back from previous highs and supply chain disruptions eased. But a part of inflation, emanating especially from the services sector, is proving to be particularly persistent.

What is the difficulty here?

Services inflation strongly depends on wage developments. The term of collective wage agreements often stretches over several years. This means that inflation can remain high for a relatively long period. However, the crucial question is whether the recent robust growth in wages is merely driven by a catch-up in real wages to offset the loss in purchasing power after the high inflation over the past few years − or whether wages are also rising so sharply because firms have to pay higher wages owing to the shortage of labour. In the first case, wage growth can be expected to return to normal once the catch-up process has been completed. In the second, wage growth may well remain high for longer. And this would mean that inflation would also remain high. We need to monitor this closely.

Where do we stand at the moment?

Wage developments currently differ widely across countries. In some countries, the catch-up process is quite advanced. In others, including Germany, the losses in purchasing power over recent years are still quite far from having been offset by higher wages. It should be borne in mind that one-off payments do not permanently increase wage levels.

How can we tell whether the second case you describe is occurring, rather than it simply being a compensation in wages following the wave of inflation?

It will take quite some time before we can see that clearly. In our projections, we foresee that employment and wage growth will moderate gradually, that productivity will recover and that firms will be increasingly willing to absorb the cost surge by accepting lower profit margins. But this is not guaranteed, so we need to look at it closely. Indeed, at the moment, wage growth remains very strong while productivity growth is negative. And it is precisely firms in the services sector that could try to pass the higher wage costs through to consumer prices. After all, demand for services remains comparatively strong. And up to now, persistently high services inflation has come in tandem with a rapid fall in goods price inflation. But this need not always be the case. For example, we see that freight costs have increased significantly and there is a threat of rising protectionism. Both factors could push up goods price inflation.

What fluctuations in the inflation rate should we expect over the coming months? Could it go back up to 3%, 4%, or even 10%?

Absent new shocks, I think very strong fluctuations are unlikely at the moment. Since November last year, inflation rates have hovered around 2.5%. And according to our projections, they will continue to do so over the course of this year, with some ups and downs in the inflation rate, partly owing to statistical base effects in energy prices.

What do you mean by “base effects”?

The headline inflation rate is strongly influenced by volatile energy prices. If energy prices stood at particularly high levels a year ago, the year-on-year comparison in the same month of this year will automatically be lower, and vice versa. But this is a purely arithmetic effect that causes mechanical fluctuations in the annual rates. Inflation is therefore likely to fall slightly in autumn before rising again towards the end of the year. However, these fluctuations in inflation are expected to be moderate around a rate of 2.5%.

What circumstances would lead you to sound the alarm bell again?

There is no fixed threshold. As President Christine Lagarde repeatedly stresses, the ECB is data dependent in its decisions − but not data-point dependent.

What do you mean by not being data-point dependent? Could you explain...

We base our decisions on an analysis of the whole range of available data. We continuously cross-check the incoming data – on inflation, wages, profits, etc. – with our projections. In that sense, a single data point such as a monthly inflation rate may well be informative, because it may indicate that we need to review the assumptions underlying our projections. But we do not make our decisions dependent on a single data point. Such deviations can ultimately turn out to be a one-off, but they could also be more systematic. If we detect such systematic deviations, we need to be attentive. That is why we are currently looking so closely at services inflation, because it has several times been higher than expected of late.

But would you say that what has been observed so far is not yet a systematic deviation from the projections?

A repeated surprise in services inflation is at least a reason for taking a closer look.

Does the ECB actually need to do much more to combat this amount of inflation, or can it wait and see what happens?

Monetary policy is particularly relevant during the last mile of the fight against inflation. We cannot assume that inflation will decline on its own. On the one hand, monetary policy has an important impact on inflation expectations, which are a key factor in wage settlements. On the other, higher policy rates dampen the growth of aggregate demand. This makes it harder for firms to pass higher costs through to consumer prices.

There has been much discussion about the ECB’s interest rate cut in June. In retrospect, can it be said that it occurred somewhat prematurely?

In June we felt we could have sufficient confidence in the future path of inflation in order to cut interest rates for the first time. But there were some data that were not fully in line with the projections. That is why we need to remain vigilant. A first rate cut hence does not automatically result in a whole series of further cuts. This is why we left rates unchanged in July and why the September interest rate decision is wide open. We are not pre-committing to a particular rate path. The pace of rate cuts will depend on the data. The same can be said for how far interest rates can be cut overall – this is also uncertain at present. Once we get closer to the “neutral rate of interest”, where monetary policy is neither expansionary nor restrictive, we need to be more cautious and assess, on the basis of the data, how restrictive monetary policy is.

The US Federal Reserve has not yet cut its policy rates at all. When could differing paths for the Fed and the ECB become a problem?

I have always been sceptical about there being a considerable divergence between the ECB’s and the Fed’s monetary policy this year. After all, the persistence of inflation is a global phenomenon. The same applies to the current large contribution of services to inflation. There is also no reason why the ECB and the Fed must act in a fully synchronised manner. We make our decisions at the ECB on the basis of all the data relevant for the euro area economy. These data are, of course, partly influenced by what happens in the United States; via the exchange rate and global demand, but also through close interlinkages of financial markets.

Are you following the US election? Is it important for inflation who wins?

We do not comment on political developments. But of course, politics affects the economy and therefore inflation. But for now we wait and see.

During the inflation wave, many people saw everyday necessities in the supermarket and at the petrol pump becoming much more expensive. Is there hope that prices will not only rise less in the near future, but that things will also become cheaper again?

A decline in inflation does not mean that prices fall across the board. In fact, it is the aim of monetary policy to ensure that prices increase by an average of 2% per year over the medium term. This is then typically reflected in corresponding wage increases, which results in purchasing power being more or less maintained. Of course, individual prices may fall, especially for goods that have previously experienced very steep price increases, such as energy.

If there were 10% price increases during the inflation wave, why would it not be a good thing if prices were to fall by 10% now?

Falling prices across the board are generally an indication of a very weak economy. Nobody wants that. In addition, there is a risk of a deflationary spiral. If prices are expected to fall in the future, households could postpone their consumption and firms could postpone their investment. This can then become a self-reinforcing process. We have rarely seen this throughout history, but it is certainly undesirable from an economic point of view.

Recently, at the ECB Forum on Central Banking in Sintra, Portugal, there was much debate about the economic causes of the inflation wave. Were you convinced by the arguments that the sudden increase in demand may have played a more important role than previously assumed?

I consider it plausible that both supply-side and demand-side factors have played a role. This is also evident in analyses conducted by the ECB, even if one may debate the exact share each side contributed. Supply-side factors included, for example, disruptions to supply chains in the wake of the pandemic or the rise in energy prices following Russia’s invasion of Ukraine. At the same time, there was a demand-driven boom when the economy reopened after the lockdowns.

Did governments’ fiscal policies and the ECB’s monetary policy also contribute to the inflation wave during the pandemic?

Fiscal and monetary policy managed to quickly overcome the most severe economic downturn of the post-war period. That was crucial. However, both fiscal and monetary policy remained expansionary for a relatively long period. This is likely to have contributed to the subsequent rise in inflation. But we should not forget that concerns about the pandemic’s resurgence and a renewed economic downturn were very high at that time.

Before the recent French election, financial markets suddenly demanded higher risk premia on French and Italian government bonds. How did the ECB monitor this development?

We are monitoring financial markets very closely because they play an important role in the transmission of our monetary policy. The political uncertainty and concerns about future fiscal policy in France led to a change in the risk perception of financial market participants, with higher risk premia for some government bonds. But at no point was there disorderly market turbulence that would have jeopardised financial stability or the transmission of monetary policy.

The ECB is now planning another strategy review. What do you think should be discussed – should the inflation target be on the table?

The inflation target of 2% over the medium term will not be up for discussion. It has served us well during the period of high inflation. It is clearly defined and easy to understand. There is therefore no need to adjust the inflation target. Instead, I would use the assessment of our strategy to learn from the high inflation period and to adapt the strategy to the changed macroeconomic situation.

What are you thinking about in concrete terms?

We are no longer in a situation where inflation is persistently too low. On the contrary, many fear that we could face inflationary supply-side shocks more frequently in the future. We should look at how we can reliably fulfil our price stability mandate in such an environment.

Recently, the question of the Eurosystem’s trillions in asset purchases was being discussed once again, specifically the extent to which they were helpful or burdened by side effects. What is your assessment of that?

We have seen that asset purchases, or their announcement, are a very effective tool for market stabilisation. But when it comes to tackling low inflation, the benefits and costs need to be weighed up more carefully. We have learned that the effectiveness of asset purchases depends on the macroeconomic environment we are facing. At the same time, we have seen that asset purchases can have significant side effects – think of central bank losses or distortions in financial markets. That is why I believe asset purchases should be more targeted in the future. They should certainly be used in crisis situations for a limited time – but we should discuss in our strategy assessment to what extent it makes sense to buy bonds on a large scale for long periods of time in order to push up inflation.