Exclusive: Transcript of Interview with ECB Governing Council member Šimkus on 05 April 2023

6 April 2023

By David Barwick – VILNIUS (Econostream) – Following is the full transcript of the interview conducted by Econostream on 05 April 2023 with Gediminas Šimkus, Governor of the Bank of Lithuania and member of the Governing Council of the European Central Bank.

Q: Governor, how likely do you think it is that the recent financial tensions will dampen the growth and inflation outlook?

A: We should not overreact to these market tensions. There were some issues with some banks in the US and Switzerland, and the authorities have taken strong measures to contain the situation. Not at all surprisingly, there were some market reactions. But the euro area banking system is very different in terms of institutional set-up, the ECB’s toolkit, macroprudential authorities, the Systemic Risk Board, banking union, the Single Supervisory Mechanism, the Single Resolution Mechanism, the European Stability Mechanism and so on. And even if we still don’t have a European deposit guarantee scheme, we do have very well-functioning national deposit insurance schemes. So, Europe is very well prepared for any kind of a crisis, and on top of this, we have a very solid banking system, with sufficient capital buffers, strong liquidity and growing profitability. So, I don’t believe that the current market tensions will have any material impact on our macroeconomic developments. Now, a change in risk aversion on banks’ part could lead them to tighten financing conditions to some extent, and this could influence macroeconomic developments. But even so, I don’t believe there will be any material impact. And with the start of the problems, we saw the sharp drop in market ECB rate expectations. But these reversed later on. So, from a macroeconomic perspective, the effect will be limited.

Q: What would be an “overreaction”?

A: Just because some other jurisdictions outside the euro area have bank problems, this does not mean that the euro area should by definition also have a problem. That however was the thinking of markets: a problem somewhere else must mean a problem here. But sitting at the decision-makers’ table, it’s very clear that we really do have a robust system. Therefore, we should not overreact to unwarranted market tension spillover, but instead should take the necessary decisions with respect to our policies.

Q: So 50bp should remain an option in May?

A: That’s not what I am saying. We have considerably increased interest rates in a pretty short period of time. And it’s very clear that accommodative monetary policy was not needed anymore. What we’ve done, not only with the rate hikes but also with the balance sheet reduction, is already having an impact. But the peak impact occurs with a lag of a year or even longer. However, inflation remains persistent. We do see a drop in the headline measure; supply bottlenecks have been easing and energy prices falling, and these developments have dampened headline inflation. But the underlying price pressures are still strong, and we see from core inflation dynamics that it’s sticky. It’s likely that core inflation hasn’t yet reached its peak. So we may have come most of the way with monetary policy, but seeing the data available now, and given our March baseline projections, I don’t see a pause in hiking rates in May as a likely scenario. Whether we should push as hard as we have in the past will depend on the data, but we still have some way to go to get inflation back into its 2% medium-term cage.

Q: And the fact that you don’t want to be explicit about allowing for the possibility of 50bp in May is because we’ve already done so much so quickly and you want to give it time to take effect.

A: Exactly. So, on the one hand, we still need to let the impact of past policy moves kick in. But we can’t allow ourselves to underestimate the inflationary pressures, and they’re strong. We see this in wage dynamics. The increase in wages is not surprising; we have strong labour markets and workers and unions are naturally trying to compensate for the substantial decrease in real purchasing power they have experienced. What we need to avoid is a wage-price spiral because of workers trying to compensate for the potential decline of future purchasing power. Inflation expectations are still at 2% or slightly above, depending on whether you look at market-based or survey-based measures, but inflationary pressures are still strong, and the underlying pressures are not so visibly diminishing. If we were to take a pause, it might be that we would need to increase rates even more strongly later on. So, we should continue doing what we need to do to kill the inflationary dragon. But after having done so much, I need to look at the data, including April’s inflation. We will also have the first flash estimate of first quarter GDP. All this will serve as a good basis for a data-driven decision.

Q: Is it not time for the ECB to start talking about a possible terminal rate, or at least a range in which the terminal rate is likely to fall?

A: There are things that everybody agrees on, such as that our primary task is to get inflation to 2% in the medium term. Indicating the terminal rate would be like providing a secondary number without a compelling reason. What you really need to do is take action when the moment of decision comes. You need to hike interest rates at that moment, not to express where you think you need to get to at some point in time in the future. Especially when the situation is developing. And it is developing. If you look back at last November, the situation was different than it is now. Anyway, the macroeconomic projections are just an expression of the terminal rate in a different form. If you look at the 2025 projections, you can imagine where you need to go.

Q: That’s another question. HICP inflation is projected at 2.1% in 2025, with core at 2.2%. This is very close.

A: Yes, it’s close. I agree. But a certain path of developments is incorporated in these macroeconomic projections. And you have to see how well real developments reflect that path.

Q: Let’s say there’s no more banking turmoil between now and May 4. And that, as you said, the macroeconomic impact of the turmoil we’ve already seen is minimal. If this is the case, then wouldn’t hiking too much in May be playing with fire? Don’t you still have to keep in mind the possibility of a new bout of volatility? You can’t too easily assume everything is back to normal, can you?

A: As we said in March, the reaction function will also depend on the strength of monetary policy transmission. Financial stability is a prerequisite for monetary policy transmission. All our conditions will be analysed and assessed at the time of the Governing Council meeting. Hiking too much or too little is the external view. From the perspective of those at the table making the decision, we’re not hiking too much or too little; we’re hiking as much as we think is needed. This emphasis on the data is particularly important this time, because it will really depend on what the data indicate. At this point in time, I clearly see that there is a need to take further steps. The data should tell us whether it is correct to move as fast as we have been moving. But I don’t think of doing too little or too much.

Q: Still, there’s an increased element of prudence now that we didn’t have before the banking sector issues, and I think the possibility of more volatility would have to be in the back of people’s minds. So the bar for 50bp should be higher than it was.

A: Typically, when you see this market reaction, in particular as regards the euro area, it’s in a way a reflection of what has happened elsewhere. But the core question is whether there are any underlying fundamentals for these things to occur in the euro area? And what I believe is that there are none.

Q: So then you literally do not have to worry about what happened in the US and in Switzerland at the beginning of March.

A: I do have to worry, because it would have been much better if these things had not happened, if the banking system in the US were healthy and Credit Suisse had not had problems. It definitely has financial market repercussions. You saw this sharp repricing of financial instruments and the drop in ECB market rate expectations, so there are clearly repercussions here. But the point is how much damage can be done in the euro area, and the stronger the system, the sooner negative developments will fade out.

Q: It’s only April now, and it looks like it’s possible that the ECB would be done hiking in June. Do you think there’s any potential for at least a small loosening of policy at the end of this year?

A: What I’m sure of is that we need restrictive monetary policy for quite some time to kill the dragon of inflation. We are dealing now with inflation and not disinflation. So, at this point, I’m thinking that we need to continue firmly with hiking and that we need to maintain the restrictive stance for quite some time. It’s very unlikely that we will see any decrease in interest rates this year.

Q: And are we in restrictive territory now?

A: I think so, yes.

Q: What is the trade-off between interest rate hikes and reducing the size of the balance sheet? Can you step up the balance sheet reduction and hike less?

A: No, no. Of course, they are interlinked, but not that directly. I see them as different tools working differently. Fundamentally, all the monetary policy instruments at our disposal should work in the same direction and reflect the same monetary policy stance. On the balance sheet, I see room for continuing in the direction we are going and taking even stronger steps, because there are some things also to consider. There are some side effects from a large balance sheet, like the distortion of income distribution and substantial growth in banking profits. And there’s a scarcity of safe assets. We don’t need such a big balance sheet in the current economic environment. So, I think there’s room to discuss doing more about reducing the balance sheet.

Q: So instead of €15 billion a month maybe €30 billion, from July?

A: I think stopping the reinvestments is one of the options.

Q: As of July?

A: We’ll see. Of course, we should be mindful of the situation. These three last years showed how the world can repeatedly change very quickly – Covid, supply bottlenecks, the Russian war against Ukraine, raw materials prices and so on. But we have a whole quarter until July, and as of now, if we see that the markets can absorb these additional securities, then - of course being gradual and consistent - we should discuss further actions in terms of the faster reduction of our balance sheet.

Q: And active sales?

A: Oh, no. Our approach to QT should be gradual and consistent and take into account the market’s capacity to absorb these additional securities. This could be an option some day in the future, but given the preconditions of being gradual and consistent, I don’t think this is an option for July. Running off the balance sheet in the background by stopping reinvestments would be one of the options.

Q: That we could do in July.

A: It’s one of the options, and given the market turbulence and volatility, it requires thorough discussions. But not active sales, I don’t think this is an option.

Q: Maybe sometime next year?

A: Next year is still next year, so it’s a long way to go.

Q: And what about the PEPP?

A: First we should continue with decisions on the APP. Let’s start with the APP and consider the PEPP later.

Q: It could be later this year that the PEPP makes it onto the agenda, though?

A: Let’s see, because with PEPP reinvestments we should continue until the end of 2024. That’s kind of a decision that’s already taken, so to change it…let’s deal with the APP and then come back to the PEPP.

Q: You mentioned raw materials prices a moment ago. Does this week’s decision by OPEC to cut output have any impact on your thinking?

A: Not really. It will increase oil and related prices. But I see it as a one-off factor. We’ve seen various raw materials prices go up and down. I don’t think, once again, we should overreact or exaggerate. There are many supply and demand factors to discuss.

Q: You said earlier that core inflation had probably not yet peaked. When do you expect this?

A: We see wages going up. We see high profits. We saw that Euro area economy did not grow, but also did not decrease in the last quarter of last year. The GDP growth projection for this year were corrected up by 0.5 percentage points. That’s not that little for such a jurisdiction as the euro area. We see inflation of non-energy industrial goods remaining strong. We see services prices going up quite quickly. We will see the peak this year. I think core inflation will remain pretty high for the remainder of this year, but it will start slowing into the second half of this year. And it is pretty sticky. We will definitely see it coming down eventually, because we have taken actions and will take some more and we will dampen it. My point is that it’s not about the precise timing of the peak, but that it’s stickier than many people think.

Q: So, you don’t think core is going to come down meaningfully and sustainably for a while. Does that all by itself obligate you to take policy action?

A: You need to react, because it’s stickier than one would have thought half a year ago. It’s not coming down quickly. So, it’s important information for a monetary policy decision-maker.

Q: How valid in your view are the latest staff forecasts?

A: I can say two things. First, again, we need to look at fundamentals and should not overreact to idiosyncratic events. Second, we should look through to the longer-term perspective. Fundamentally, nothing has changed that much, though, underlying price growth seems to be stickier.

Q: On the subject of the corridor system versus the floor system…

A: It’s an important question. These discussions on the operational framework of monetary policy are very important, particularly in this environment of excess liquidity and a big balance sheet. But this is still something that remains to be done, and the sooner the better. Definitely this excess liquidity has side effects, because these inflationary pressures kicked in so quickly, so we need to get to these discussions as soon as possible.