ECB’s Knot: Policy Must Turn Restrictive; Should ‘Test the Waters’ with QT Before Deciding Ultimate Pace
18 November 2022
By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member Klaas Knot on Friday said that ECB monetary policy had to become restrictive in order to slow demand and called for quantitative tightening to start early but be cautious.
In a speech at the European Banking Congress, Knot, who heads De Nederlandsche Bank, said that he expected ‘to reach broadly neutral territory at next month’s policy meeting’, at which point the ECB would neither be stimulating nor slowing economic growth, but that this would not be enough.
‘For the ECB, the overall game plan remains obvious’, he said. ‘Our response needs to be resolute, implying that monetary policy needs to enter restrictive territory to dampen demand.’
‘How fast and far ongoing rate increases will bring us into restrictive territory is surrounded by uncertainty and will be evaluated meeting by meeting’, he said. ‘As the stance of monetary policy tightens further, it will become more likely that the pace of increases will slow. In any case, our priority going forward will be the need to rule out the risk of persistently high inflation.’
All the ECB’s instruments ‘need to work in the same direction’, he insisted. ‘It would not be consistent to keep a large balance sheet to compress the term premium, while at the same time tightening policy rates above neutral.’
Quantitative tightening should be governed by four principles, he said. Among these are the need for policy rates to have primacy and the importance of not treating APP holdings like PEPP holdings, he said.
‘The former exclusively steers the monetary stance, while PEPP continues to serve a dual purpose, by also countering fragmentation risks to monetary transmission’, he explained. ‘Therefore, decisions about unwinding these two programmes do not have to run in parallel. I expect the APP roll-off to start significantly earlier than that of PEPP, for which reinvestment is communicated to last until the end of 2024.’
Another principle is caution, which he said ‘calls for an early but partial stop to reinvestments, to test the waters before calibrating the ultimate pace of the roll-off.’
‘And finally, QT should be predictable, like watching paint dry, as the saying goes’, he concluded.
Knot noted that euro area HICP had just reached double digits for the first time, ‘and even more worrisome from our perspective, core inflation (excluding energy, food, alcohol & tobacco) reached an all-time high at 5.0%.’
Risks, he said, are still predominantly to the upside and include the ‘very real risk of second-round effects’. At the same time, the most recent data indicate ‘that the economic outlook has deteriorated further and that the risk of a recession has increased.’
While growth has to slow to reduce inflation, ‘it is far from certain that slower growth or a mild recession alone will be enough to drive inflation back to levels around 2%’, he said.
Knot identified two reasons for the ECB to ‘persist in our efforts until we have reached our goal, no matter how difficult this proves.’ One was the possibility of inflation becoming entrenched in economic agents’ thinking, which could trigger second-round effects and would lead to a situation in which high inflation persisted even longer and required greater effort to subdue, he said.
There is no ‘clear evidence’ of a wage-price spiral in the region, though tight job markets ‘point to rising risks of a further acceleration of wage growth’, he said. ‘[L]ike inflation, wage growth has also become increasingly broad-based. We will need to be on high alert for any feedback loop to prices.’
‘Moreover, measures of inflation expectations for several types of agents point to mixed evidence on their anchoring to the ECB’s inflation target’, he said. ‘Uncertainty and disagreement on future inflation have increased for all agents, and so has the probability they attach to high inflation over the long run.’
The other reason for the ECB to do whatever it takes to restore price stability related to the fact that a ‘broadening of inflation to a wide spectrum of goods and services points to aggregate demand factors also being at work’, he said.