ECB’s Schnabel: Terminal Interest Rate Lies in Restrictive Territory
24 December 2022
By David Barwick – FRANKFURT (Econostream) – The European Central Bank will have to take official borrowing costs into restrictive territory in order to get inflation back to a level consistent with price stability, according to ECB Executive Board member Isabel Schnabel on Saturday.
In an interview with German daily Frankfurter Allgemeine Zeitung, Schnabel called the neutral interest rate ‘more of a conceptional framework than a tool that helps our actual decision-making.’
‘In any case, we clearly have to reach an interest rate that is high enough to bring inflation back down to 2%’, she continued. ‘According to our assessment, this interest rate lies in restrictive territory – that is, above the neutral interest rate – even if the exact level is yet unknown. This means that the inflation problem will not go away on its own.’
The threat of excessive policy tightening is currently still ‘limited, as real interest rates are still very low’, she said.
Financial markets’ earlier assumption of slower tightening following any indication of an inflation turning point made the Governing Council’s most recent decision ‘so important’, she said, observing that President Christine Lagarde had made clear that hikes would continue ‘for as long as necessary’.
‘Financial markets reacted to this immediately’, she said. ‘The terminal rate, which is the peak rate expected during the interest rate cycle, has risen above 3%. Whether we will still need to go higher than that will depend on the future inflation outlook.’
The point ‘was to clarify that the terminal rate may be higher than many market participants expected’, she explained. ‘How exactly that rate is achieved is then of lesser importance. What mattered is that we agreed that further interest rate hikes are necessary.’
However, she conceded, it ‘will certainly not get any easier in the future’ to reach consensus within the Council, and from governments as well ‘we can expect increasing pushback’.
Asked whether she had confidence in the staff forecast of 2025 HICP at 2.3%, Schnabel responded that uncertainty was high and that the assumption of central bank credibility led models to envisage an eventual return of inflation to 2%.
Inflation was in any event seen as persisting well above 2% for a long time, and this by itself could influence wage and price developments, she said. ‘A long phase of very high inflation – as we are currently seeing – is therefore problematic’, she said. ‘It makes it all the more important for us to react decisively.’
Whilst reiterating that interest rates were the preferred policy tool, Schnabel judged the ECB’s balance sheet ‘incompatible with the current inflation outlook.’
‘We need to reduce it gradually, ideally in a predictable way, quietly in the background’, she said. ‘With such a measured approach, we want to avoid disruptions in the bond markets.’
Such disruptions are more likely when interest rates are rising, and consistently hiking rates is possibly only in their absence, she said. This is the justification for retaining the flexibility of PEPP reinvestments and for the transmission protection instrument (TPI), she said. ‘It is this combination of measures that made our large interest rate steps feasible’, she said.