ECB’s Lane: Must Keep Open Mind on Appropriate Level of Interest Rates, But Can Hike Further for Now

17 January 2023

By David Barwick – FRANKFURT (Econostream) – The European Central Bank has to be open-minded in deciding where interest rates need to be, but at the moment has to tighten monetary policy further, ECB Executive Board member Philip Lane said Tuesday.

In an interview with Financial Times, Lane said that current interest rates were ‘in the “ballpark” of neutral’, but ‘still not where the risks become more two-sided or symmetric’, implying that ‘we need to raise rates more.’

This will change with additional tightening, at which point the ECB ‘will have to balance the risks of doing too much versus doing too little’, he said. ‘This is not just an issue about the next meeting or the next couple of meetings, it’s going to be an issue for the next year or two.’

The ECB must take a ‘data-dependent, meeting-by-meeting approach, to make sure we adjust to the evolution of the two risks’, he added, obliging it to ‘keep an open mind on the appropriate level of interest rates.’

The worst mistake would be stubbornly sticking to the wrong view, not merely over one or two Council meetings, he said. ‘The issue here is flexibility in both directions to make sure that policy is adjusted in a timely manner, rather than maintaining a fixed view of the world for too long’, he said.

Asked where the terminal rate lay, Lane invoked data-dependence and high uncertainty.

‘Let’s just take one concrete example: compared to where we were in mid-December, when we had our last meeting, there have been big declines in energy prices’, he said. ‘A lot of that has to do with mild weather in recent weeks. So, this is a simple example of why we must be open about where interest rates need to go.’

The ‘vast majority’ of models run by the ECB indicate a need for rates to climb further, he said. It is ‘still safe’ to hike, but to what extent precisely ‘will depend on a lot of factors’, he said.

After base effects do most of the work in suppressing inflation to a projected 3.6% in Q4 of this year, the question for rate-setting is how to get from there to price stability in timely fashion, he said.

There is also uncertainty related to what different models say about how inflation responds to interest rates, which is why ‘one of the big issues for this year is to observe the impact of the tightening we’ve already done’, he said.

The terminal rate will be determined in part on the basis of ‘a feedback loop from experience’, he said. The impact seen this year of rate hikes implemented last year ‘will help us decide how powerfully the interest rate hikes are affecting the real economy and the inflation dynamic’, he said. This is the ‘prudent approach’ to the terminal rate.

With banks and financial markets reflecting the yield curve’s shift over the last year, ‘[t]he interesting phase now is the response of firms, households and governments to the change in financial conditions’, he said.

In comparing the Eurozone’s economy with that of the US, Lane said that independent of the source of inflation, there is a risk of second-round effects, which monetary policy must ensure do not become ‘excessive or persistent.’

The euro area requires less policy tightening than the US because of the hit to real incomes here, he said. As a result, ‘delivering 2% means that interest rates will differ substantially between us and the US’, he said.

An environment of chronically weak inflation won’t return, he said, noting that talk of ‘Japanification’ of Europe had ceased.

‘So, if expectations have now re-anchored at our 2% target, compared to being well below it, interest rates will go to the level consistent with that target, not back to the super-low rates we needed to fight below-target inflation’, he said.