EXCLUSIVE: ECB’s Kazāks: If Economy Surprises to the Upside, We’ll Move Faster Than Now Foreseen

29 July 2021

By David Barwick – FRANKFURT (Econostream) – The European Central Bank is at no particular risk of falling behind the curve with its monetary policy and needs to avoid the mistake of premature tightening, but if economic developments surprised positively, then it would act faster than now expected, according to ECB Governing Council member Mārtiņš Kazāks.

In an interview with Econostream on Wednesday, Kazāks, who is Governor of Latvijas Banka, said the euro area had been evolving most recently in a manner consistent with the June Eurosystem staff macroeconomic forecasts, but various developments made him a bit more optimistic about inflation at the end of the projection horizon.

Still, the economy continued to need time to recover and wage pressures remained too weak to provide a durable foundation for currently stronger inflation, he said.

 Kazāks said that the June ECB Survey of Monetary Analysts had shown markets to be anticipating lift-off with inflation still far below 2%, a ‘misleading’ understanding that the ECB’s new forward guidance addressed.

Asked how much danger he saw of the ECB’s monetary policy getting behind the curve and requiring an unnecessarily sharp correction, Kazāks said he saw no such risk beyond the ever-present possibility of a surprise.

‘But if anything, what we have learned from the past is that we should not make the mistake of premature tightening’, he said. ‘Of course, we are careful. … We are not behind the curve, but if the economy surprises to the upside, then we will move more quickly than we currently envisage.’

The current staff projections, last updated in early June, are still ‘pretty much in line with what’s happened’, he said. However, with respect to inflation, ‘I would be somewhat more optimistic towards the end of the forecast horizon’, he said.

In addition to fiscal developments in the US, ‘[w]ith the new strategy and the new forward guidance, I would see inflation somewhat higher than we currently project it, but we will need to discuss it and see how the economy develops’, he said. ‘Covid is still a major risk.’

As for growth, ‘the economy overall may bounce back more strongly than we expected’, he said. ‘But there is still the downside, and of course the best example of that is the Delta variant. We don’t know what’s going to come out of that. So we have to be cautious, and this cautiousness will also guide our policy decisions.’

Kazāks defended the ECB’s track record despite the recent tendency to revise forecasts upwards after previous assessments of downside risks, saying he agreed with the assessment of the balance of risks.

‘Uncertainty has been very high and we have seen inflation surprise us on the downside in the past’, he observed. ‘The current labour market still shows a quite significant amount of slack and we don’t see the strong wage pressures that it would take to make current inflation more persistent. So the economy still needs some time to recover. By and large, I think the Council has been very correct in its assessment and the balance of risks.’

The June ECB Survey of Monetary Analysts indicated that ‘markets were expecting that we would start lift-off at inflation levels way below 2%’, he said. ‘I think their understanding was misleading in this respect. With the inflation target now at 2% and symmetric, we would not be that willing to move with inflation rates so far below 2%. And our new forward guidance very clearly says this. The major problem was markets’ misunderstanding in terms of our lift-off inflation level.’

The new forward guidance makes the ECB’s reaction function clearer without depriving it of flexibility, he said. The Governing Council’s actions would be state-dependent and ‘as we see appropriate at each moment’, he said. ‘We’ve provided more clarity, but without tying our hands.’

The condition for lift-off that inflation must reach 2% ‘well ahead’ of the end of the ECB’s projection horizon is an example of this, he said, and monetary policymakers ‘can react somewhat differently if it’s a demand shock or a supply shock.’

In the current context, given ample reason to think inflation would subside again in 2022, ‘what this forward guidance story is telling is that it is not sufficient in terms of our forecast if we see inflation at 2% at the end of the forecast horizon, or even somewhat above 2%’, he said. ‘Because the further you look, the greater the forecast errors.’

Reducing the room for error is achieved by considering ‘well ahead’ to mean the midpoint of the projection horizon referred to by ECB President Christine Lagarde, he said. ‘So your forecast errors become smaller and you’re much more certain about the inflationary dynamics going forward.’

As for the ECB’s willingness to countenance ‘a transitory period in which inflation is moderately above target’, this was just part of aiming for 2% symmetrically over the medium term, he said. Although there would be no deliberate compensation for past undershooting, he elaborated, ‘if we see inflation moderately above 2%, but also see that due to past shortfalls instance inflation expectations have decreased with a risk of dis-anchoring, then in such circumstances I would consider it possible or even necessary for us to wait somewhat before acting until inflation expectations recover and climb closer to 2%.’

Kazāks agreed that it was ‘still premature to talk about phasing out the PEPP’, as the programme still had until at least next March to run. ‘If we see that we need to support the economy more, we may increase the size or the time frame, and vice versa as well’, he said.

Uncertainty remained too high for such a discussion now, he said. ‘Of course, we will not surprise the markets in March by saying, “That’s it. We’re done.” That would be too late. We don’t want to create excessive volatility and jittery markets. So when the time comes, we will let the markets know about our deliberations and decisions.’

It was not just the time frame that could determine when asset purchases would need discussion, he made clear. ‘If we see significantly less uncertainty and significant economic strengthening, then we will communicate accordingly’, he said. ‘But this is not the moment yet.’

There was also ‘no need to rush’ into a discussion about what would allow the ECB to counter market fragmentation post-PEPP, he said. In this context, he said, it should be stressed that ‘we have a wide set of instruments, and if we see that they are not sufficient, then we will devise new ones, within our mandate of course and in line with our analyses of proportionality and legality and so on.’

 ‘[T]he end of PEPP does not mean the end of support to the economy’, he said. ‘We have other programs that will support the economy, and if we see that we need some additional, transitory elements, then we will discuss it. Flexibility is important. It’s going to be state-dependent and we will act as best for the economy.’