Source: European Central Bank
Interview with Philip R. Lane, Member of the Executive Board of the ECB, conducted by Balázs Korányi, Francesco Canepa and Frank Siebelt
1 July 2020
We appear to be seeing two opposing trends in macro fundaments. Economic indicators, like the PMI, the Ifo or inflation, are coming in above expectations. But we are also seeing a sharp increase in infections around the globe. How do you square these trends?
We have a medium-term perspective, so what we focus on is different from what a stock market analyst might focus on. We have a projection horizon of around two years to 2022 and since monetary policy works with a lag, we are more focused on what happens a year from now, 18 months from now, 24 months from now, than on day-to-day fluctuations.
It’s possible for all of these developments to be occurring simultaneously, because we are in a multi-phase process. The second quarter is definitely the lowest point, but already in this quarter we had a significant first step in the recovery process. So, we are in the second stage of recovery and the big question is how much this initial bounce tells you about the speed at which we get back to the pre-crisis level.
We’ve done a lot. We have essentially this one-year horizon. We’ve put in place the PEPP for another year. The market has stabilised quite a bit compared to March but remains above the pre-crisis levels. We think it’s going to take a lot of time and that one-year horizon reflects that before we really know how able the European economy will be to recover from this shock. These weeks of the initial bounce don’t really provide a guide to what’s going to happen in the winter. We’re in for a long period where the data should be mostly positive, because the projection is that we’re going to grow compared to the bottom in April. Whether it grows at the same speed or we get an initial bounce and then it levels off it’s not going to be so easy for us, you or the market to navigate or extract useful signals from the data. There’s going to be a lot of noisy data and we really have to settle in and recognise that there isn’t going to be full clarity about the medium term for many months.
There’s an additional question: when we get back to the pre-crisis level, which we think is around the end of 2022: are there long-term scarring effects? The fact that there’s a good bounce right now is good, but it doesn’t tell you that much about the overall recovery profile. And that goes back to the point you made about infections, which is this kind of “two steps forward, one step back” profile, where it looks like you can make progress but then there can be a localised problem. That’s what we have in our scenarios. We have partial interruptions this year and next year. We think that the European economy and probably parts of the global economy will have partial interruptions, either precautionary or in response to mini outbreaks. That’s why we think it’s going to take a long time for output to fully recover. It’s not just about the initial unlocking of the economy, it’s about that persistent interruption of normal economic life, and connected with that is the contribution of regulatory measures, such as lockdowns and the associated nervousness of households and firms. When you get reports of infections or reversals, prospects for consumer confidence and investor confidence to fully recover quickly are diminished.
Given a better-than-expected June inflation reading, are you now more optimistic that the risk of negative inflation has been eliminated?
Even in our severe scenario, we didn’t really have inflation going negative. All of this is in the context of a very large fiscal and monetary policy response. The risk of negative inflation is there but, in our scenarios inflation will remain quite low, while remaining in positive territory. It’s good news that the inflation numbers coming out are better than expected. But going back to my first point: it’s good, but it doesn’t tell you all that much about inflation in the medium term.
You have undershot your inflation target for seven years and it won’t rise back to target within your projection horizon. At what point do you say that what we’re seeing is no longer a shock but the new normal?
Do we have evidence that monetary policy affects inflation? The answer is yes. Our policies over the last several years have had a significant effect on the inflation rate. In the absence of the measures taken by the ECB, especially since 2014, we would be in a situation of much lower inflation, maybe even negative inflation. Remember: Japan spent about 15 years with negative inflation. It’s a two-level challenge. First, stabilising inflation at around 1% should not be discounted as a minor achievement. But, second, it’s quite important to continue to push inflation closer to 2% – and the pandemic illustrates why this is important. The European economy would be a lot safer, and our ability to deal with this type of shock would be much more enhanced, if we had an inflation rate closer to 2%. This would mean that the policy interest rate under a full recovery would be a lot higher, and we would have more room to respond to a negative shock with cuts in the interest rate.
The ECB has consistently said that this process of returning inflation to levels that are closer to 2% takes patience because we can’t make dramatic monetary policy moves. Interest rates are already pretty low and while we have effective extra tools like asset purchases, we can’t do the standard central bank routine of 20 years ago of reducing interest rates by 500 basis points in a recession.
But at what price can you do this? German Constitutional Court judges may be no economists, but they raise some concerns that are close to people’s hearts. House prices have risen sharply and this is partly because of ultra-low rates and excess liquidity. Certain capital-guaranteed saving products are no longer viable because of how bond yield behave under your policy. So, what’s the cost of what you just described?
A lot of what you just said is true because of the low equilibrium real interest rate, the so-called r*. And there’s no way getting around that. So the low interest rates are not just an arbitrary decision of the ECB. If the European economy has a low desire for investment compared to a high desire for savings, then the European economy can only have something reasonably approximating full employment and a path of inflation back to levels closer to our inflation aim if the rate the ECB sets is below the equilibrium rate. It is important to keep in mind that in the last decade, since the last financial crisis, governments were trying to greatly reduce their deficits or run surpluses. So, we had a significant fiscal contribution to total savings. But now, with the pandemic, a lot of that firepower has been put into action. Large fiscal deficits would be one way to address the aggregate savings issue.
Right now we have a big surge in household savings and the precautionary motive for household savings will be a big question. On the investment side, part of the way austerity worked was through a big reduction in public investment. That may be going in reverse now. So, most of what you said about how the financial system operates, reasonable expectation of savers, those hoping to buy a house, I really think the role of monetary policy in all that is minor. If, instead, we were to raise the interest rate when it’s not warranted, it would lead to a lower inflation rate and we would see an even longer period of very low interest rates.
We heard already back in 2016 that you need lower rates now to have higher rates later. But when does the future becomes the present?
If you go back, 2017 was a good year for the European economy and we started pulling back on the asset purchases. But then we had new shocks. Maybe the deeper question here is: why is the world economy and the European economy going through what turns out to be a sequence of negative shocks, with only temporary periods of good news in between?
My view is that some of those negative shocks cannot be sustained, some of them have the seeds of their own demise. So, I don’t see the world as always having these negative shocks and this is why central banks have the ability to reverse course. We have to be proactive in both directions. We have to be proactive in the direction of easing this year, because it is a large negative shock. But over the course of the last five years, since I have been on the Governing Council, we have also pulled back, we did shrink the asset purchase programme, and we did bring asset purchases to zero when we thought we could.
Some doubt this and argue that central banks are monetising debt. The best way to prove they are wrong is to have an exit strategy. What’s your exit strategy?
We have multiple exit strategies. We said what the exit strategy is from the APP and from negative interest rates, which is inflation robustly converging to our inflation aim. And then we have a sequence of lifting the policy rate and then starting to shrink the APP asset portfolio. On the PEPP, we will end the purchases when we conclude that pandemic crisis phase is behind us. We have also given guidance on reinvestments. Our forward guidance is full of exit strategies.
But what if you can’t exit? Are public debt levels a constraint? As soon as you start talking about an exit, yields rise. Last time you went only 9 months without buying bonds, which is not much.
The question you are posing in essence says that the European economy cannot grow sufficiently quickly and inflationary pressures are not going to be that strong so long as debt is at a certain level. This is not an unconditional truth. This idea that debt levels trap us, I just don’t see it. But what is true is the only real way to prove this is through action. I am confident that when we have the conditions which we laid out in our forward guidance, when those conditions apply, then we can move and exit.
You’ve pointed out that shadow banks contributed significantly to market stress in March and April. So why not open your balance sheet to some of them, at least investment funds and insurance companies?
We did list the role of non-banks in the transmission mechanism as a topic for the strategy review.
For now, it’s true that we don’t provide them with direct access to our balance sheet. But the fact is that banks have a lot of access to liquidity from us. Banks have a special role in the economy in terms of intermediation, and there is strong supervision of them. We ended up with a pretty generous asset purchase programme, which is not just the sovereigns but also corporate bonds and commercial papers. In addition, we made the targeted lending programme even more attractive. The combination of liquidity to banks, which can make loans if needed or have other transactions with these other intermediaries, and the asset purchases turned out to provide a lot of stability.
Corporate downgrades have been few, perhaps because of the fiscal response, including public guarantees. Do you think that downgrades have been avoided or is there still a wave coming?
Rating agencies are forward looking and they are probably in a wait-and-see mode. The initial period of instability was addressed quickly, so the feared illiquidity spiral has not happened. What remains an open question is how much earnings will be lost by corporations. In some areas, like airlines, there was a pretty immediate hit. But to me, current ratings look like a reasonable balance, which is that it is too early to tell. Under the baseline of a significant recovery in these weeks and months, the case for lots of downgrades is a lot less than if you ended up in the severe scenario where there is a second wave of rating downgrades. I think there is a very wide range of possible outcomes but as of right now, it’s not obvious to me, the data are not compelling to say that there should be a lot more downgrades.
Does that mean that there’s no urgency in discussing buying sub-investment grade corporate debt?
I think our approach is contingent on the data we see. Compared to where we were in mid-March, the scale of the improvement in market stability has already delivered quite a lot. We have a very liquid banking system, we are supporting a lot of credit, we have scaled up our activities in commercial paper and corporate bonds.
In March, the ECB initially decided to only increase bond buys by 120 billion euros and you were still talking about a “temporary shock”. But six days later you unveiled PEPP and a much more aggressive stimulus package. Markets sold off sharply during that period but strictly from a pandemic point of view, the situation had already been clear beforehand. Granted that hindsight is always 20/20 and no-one has a crystal ball, what would you do differently and what have you learnt from that experience?
Let me just make one basic point about monetary policy, which is very important, as demonstrated not just by us but by the Fed and everyone else who had unscheduled extra meetings. Any decision we take is always in the context of “if more is needed, more can be done”. Conditional on what we knew on 12 March, the move we made on that day is reasonable. There is always a risk that it wasn’t going to be enough. But we do have the ability to hold meetings out of the normal calendar, if it turns out that we need to adjust. Unlike fiscal policy, which has a much more difficult decision-making process, monetary policy has that flexibility.
When the history books are written, those seven or ten days will be quite something in terms of the minute-by-minute narrative. I think 11 March is the actual date the pandemic was declared. Then on 15 March, the Sunday evening, the Fed came out with their own statement, which obviously had a dramatic effect on the market on Monday. Then in terms of the actual lockdown measures, on 12 March, the day of our meeting, various countries announced lockdown measures and there were more measures announced on Monday 16 March. I think we can always reflect and say “should we have moved more on 12 March?”. But I think a lot did happen between 12 March and 18 March.
One of the big developments in those days is that the market crashed, and we know from your blog posts that you do watch financial markets closely. Do you see scope for the ECB or for a central bank to operate a bit more autonomously from the markets, which as we know have vicious circles built into them such leverage, herd behaviour and margins calls.
There is a long-running debate about the interaction between monetary policy and the market, which is different from the question you ask. One type of question is a cycle where markets in advance of monetary policy meetings form an expectation about what we’re going to do and whether that influences the decision making. So, under this narrative, “we don’t want to disappoint the market”. And, in that sense, the central bank is perceived to be influenced by markets. This “hall of mirrors” conundrum is a long-running debate.
But a different point is that once the market goes under extreme stress a central bank has to intervene. The question behind this is: can we not design a regulatory system which reduces the risk of that kind of extreme stress? We think it’s been so important in this pandemic that this was largely addressed in the banking system. We have seen a lot of credit being provided in the last number of weeks. The banks have started this crisis with much higher capital ratios, much better liquidity ratios, less severe leverage ratios compared to previous crisis. So, there’s lot of progress in making sure the banking system was not a source of amplification in this crisis. The ECB has been consistent, whether under the current Vice-President or his predecessor beforehand, in highlighting that the same macroprudential insulation is not there for non-banks. So it is clear that having more macroproduential insulation in terms of more liquidity and less leverage makes the system less prone to shocks. But given the size of this shock, what we have now is a really large shock. So in case of tail events the central bank will be called upon to intervene.
Why do you only see the stress once the financial market flags it to you?
That’s essentially the way the central bank operates is in terms of influencing financial conditions. If financial conditions are in line with what we need, then we don’t have to intervene. If financial conditions get too tight, then we must offset that. So there is a direct connection between financial conditions and what is the appropriate stance for monetary policy. It really is about that transmission. Outside of stressed conditions, financial market participants are looking at the same macro data as we are. Financial conditions tend to move in the same direction we would move them anyway. Because we’re both looking at the inflation data, the hard data. That’s what simultaneously drives the market and determines our own projections. Most of the time, there is a deep interconnection between the market view and the central bank, because they’re both driven by the underlying fundamentals facing the world. But under conditions either of stress or bubble, they start to have an independent contribution.
When you say you fight unwarranted tightening in spreads, regardless of your definition of unwarranted, at some point that has to translate to basis points. Because, at some point, you to make a decision on “we buy now…”
This can be explained in different ways. You see, by the way, other episodes where spreads have gone up and the ECB has not responded.
So we are not, absolutely not, into yield-targeting or yield-curve control, that’s not part of what we’re doing. We don’t take any particular view on the level of the spread. What we do look at is whether financial markets have become one-sided. If there has been this kind of flight to cash, flight to safety, if everyone is trying to sell, then there no individual intermediary is going to be ready to stabilise the market by being on the buy-side. This is exactly the same as what we saw in the U.S. Treasury market. You can definitely have, in any market, the risk of a severe overshooting, because of the mass of traders who are trying to make the same trade, which at that time was to deleverage and raise cash.
So you can have a one-sided market, which you know will lead to overshooting. This is why the Fed intervened big time in the Treasury market in the U.S. In the euro area this is compounded by the fact there are 19 countries and you can switch between their sovereign bonds with no currency risk: The risk of instability is compounded by the fact that it is so easy to switch away from more vulnerable countries to less vulnerable countries. That switch could even occur when there is no change in fundamentals, when there is no change in macro projections. It can be entirely belief-driven. If you believe every other investor is running to the safe haven, it is individually rational for every investor to also run, so the market becomes one-sided. The central bank essentially acts as a stabilising force.
But that stabilisation is not a statement about the level of the yield. Because, as you know from the yield control debate, the only credible yield control or yield-targeting approach is a promise to buy everything. You can only target the yield if you promise to buy everything, which we do not. We announced a substantial programme and we said we’re going to use it flexibly. But in no sense it’s a kind of promise to deliver any particular type of spread.
It worked in the way I expected. The announcement effect on March 18 led to a big initial drop in yields, because what mattered to the market was that it was no longer one-sided. Once you know there’s a significant stabilising force, that risk is eliminated. Lots of other risks remain and we don’t try to eliminate spreads. But the announcement effect was itself proof that the market had become unstable.