ECB’s Knot: Risk of Retracting Policy Support Too Soon Worse than Being Too Quick

16 April, 2021

By David Barwick – FRANKFURT (Econostream) – The possible consequences of removing policy support prematurely are probably worse than those associated with leaving it in place too long, European Central Bank Governing Council member Klaas Knot said Friday.

In a speech at a Eurofi seminar, Knot, who heads the Dutch National Bank, compared the European economy to a patient nearing the end of the emergency phase and ready to gradually concentrate on recovery.

‘In terms of the European economy – once we approach the recovery phase, we could start discussing the withdrawal of emergency support measures, which would also mean gradually allowing market forces back in’, he said. ‘However, we should tread carefully in all scenarios, because the risk of retracting policy support too quickly will likely continue to outweigh the risk of unwinding it too slowly for some time to come.’

It is particularly important that fiscal support be left in place ‘until we have made a good start with the recovery’, he said, which ‘may well take us to year-end at least.’ Blanketed support can be gradually replaced by targeted support ‘[o]nce the worst is over’, he said.

Policymakers must keep in mind the tradeoff between treating the patient so long that withdrawal symptoms result and withdrawing support too soon, potentially ‘putting a healthy recovery back for many months’, he said. That implies a need to ‘adjust the pace and sequence of tapering measures accordingly.’

Noting that insolvencies and unemployment had so far been ‘relatively subdued’, Knot said that the economy had ‘done consistently better than we anticipated about a year ago.’ Still, companies, especially in some sectors, had not emerged unscathed, he said.

‘The banks have been the bright spot in this story so far’, he continued. ‘They have generally remained resilient and continued to provide credit to the real economy.’

The banking sector’s relatively good condition reflects both reforms taken in recent years as well as the protection from insolvency-related losses due to policy support, he said. ‘As a result, the policy response to the crisis has increased the dependency of governments, banks and business on one another’, he said.

Although the sovereign-corporate-bank nexus is currently ‘vital’, it entails risk that could materialize in the event of mass insolvencies, he said, as the consequential bank losses would require support from governments that would in turn impact the latter’s fiscal position, thus hurting banks holding the sovereign’s debt.

‘Luckily, the risk of such a doom loop has diminished with the vaccines and the prospect of economic recovery’, he said. ‘But at the same time, it is clear that the virus will continue to linger for quite some time to come.’