Exclusive: Transcript of Interview with ECB Governing Council member Wunsch on 15 April 2023

19 April 2023

By David Barwick – WASHINGTON (Econostream) – Following is the full transcript of the interview conducted by Econostream on 15 April 2023 with Pierre Wunsch, Governor of the National Bank of Belgium and member of the Governing Council of the European Central Bank.

Q: Governor, you recently said that ‘[i]f there's another upside surprise in core inflation and the lending survey doesn't look too bad, we might have to do 50’. How bad would the lending survey have to be?

A: I don’t expect it to be bad. Core however has been surprising on the upside. In December we thought core would stabilise slightly above 5% in Q1 and then start going down quite fast. The fact that we have a reading of core at 5.7% with lower energy prices again confirms that our models tend to underestimate the inertia or persistence of core. And if we have a high reading of core for April, before the May monetary policy decision, then we would really be in a scenario where we need to do more. What could mitigate that is bad news on the credit conditions front. But this seems to be more of a concern in the US, where it seems to be a question of not whether but rather to what extent. In Europe it is still an open question whether there is going to be an impact on credit conditions. As I’ve said before, we’ve tortured the data in all directions, and what we see looks good. There is always the question of what we don’t see, but buffers, liquidity and capital are high in Europe, so it’s not like banks are now forced to hurry and increase their buffers by tightening credit conditions.

Q: So, both factors – core and lending – will probably argue for the higher policy option in May rather than the lower one.

A: Compared to what we had in the projections in December, we’ve had four readings of core that were higher than expected. A fifth reading would be a quite strong argument to do more. And the market expectations of the terminal rate are now at 3.75%. If the question is how we get there, one option is quite slowly, but another way would be to hike by 50bp and then slow down. And again, a high reading of core might at least push me to defend 50bp. But if we were to have a surprise in the other direction, I think 25bp would also be a reasonable step. I haven’t decided yet whether I’m going to defend one or the other. What we’ve seen also in the recent path is hawkish decisions that went with some dovish wording, and sometimes when we thought that a decision should be received by markets as hawkish, markets considered it to be dovish, and conversely. So, the decision could be for 25bp with more hawkish language, or it could be 50bp but presented dovishly. I don’t think we are going to do another succession of 50bp. Where market expectations are now, at 3.75%, looks to me like probably close to where we want to go, on the basis of what I know today. Of course, there can be a surprise in one or the other direction. I would probably be open to both options and I’ll see what the data tell us.

Q: A lot of your colleagues seem to agree with the idea that 25bp is the default option in May, with 50bp only if the data clearly support it.

A: We all said we were going to be data-dependent, so I don’t know if they’ve already decided on 25bp. It looks to me like the minimum. I believe 50bp should be part of the discussion.

Q: Not all upside inflation surprises are the same. To me it seems the bar for 50bp in May is not so low that any upside surprise in inflation would be sufficient. Or would any?

A: I don’t think you can attach too much weight to one single reading. It’s more that we’ve had a succession of core readings that have surprised on the upside. Also, the economy is doing better than we expected; we revised growth upwards. Fiscal policy remains supportive, probably too supportive, with a risk that the endgame turns out to be higher deficits, more support, higher rates and yet higher deficits. Clearly, monetary and fiscal policies are not going in the same direction nowadays in Europe, which by itself is already an issue. But core is now higher in Europe than in the US, and in the US, the federal funds rate is close to 5%. I would not exclude that we have to go to 4% in Europe. It doesn’t seem crazy when you see that the US is close to 5%, with an inflation rate that is now lower than we have in Europe. I’m not saying that I’m pleading for that, but if you just take a step back and look at the situation, momentum is now stronger in Europe than in the US, and we are only at 3% while they’re close to 5%. So, directionally, we might have to go higher than the 3.75% currently expected by markets. I’m not saying that I’m defending that, because I’m very comfortable with the idea that it’s going to be meeting by meeting and data-dependent. But the idea that we are very close to the terminal rate, I honestly don’t read that from the data. Of course, then the question is, what does it mean to be very close? We have already increased rates by 350bp, and we are not going to do another 350bp, that’s for sure. But I would not exclude that we have to go above market expectations, if inflation readings keep surprising on the upside.

Q: That reminds me of something you said back in March, namely that we ‘still have a long way to go’, and you also suggested then that a terminal rate of 4% could be reached. You still support the latter idea.

A: Since then, we have the confirmation that gas prices seem to remain low. But there is a risk now, if not of recession, then that the US slowdown will have an impact on Europe. So, I probably would be more cautious. In March I said I would not be surprised if we had to go to 4%. We should not exclude it. In the meantime, we’ve had negative core inflation readings. But headline inflation is going down, and I need to recognise that. It’s good news. It’s clearly going down.

Q: And does the recent decision by OPEC influence your thinking?

A: To the extent that it has an impact on oil prices, which are going to have an impact on inflation, it should be of course part of the story. How big is the impact? I can’t say yet.

Q: If the data per se argue for 50bp in May, how much weight does the argument carry for you that all these previous measures are still in the pipeline and we should wait for the impact to unfold?

A: If you look at market expectations, real rates may be slightly positive, depending on the term that you look at it. But essentially nowadays they are still spot negative, and they converge to zero over a five-year horizon. For people that have taken a position in the market, of course 350bp of hiking is a lot. So, there you might indeed have vulnerabilities, although again, we’ve tortured the data and we don’t see much. But for the real economy, and for agents that have to take decisions on the basis of the real interest rate, I don’t see a lot of tightening, honestly. There’s clearly been tightening for financial agents, and that can have an impact at some point, but for investors and households, it’s not that tight.

Q: To what extent is the talk of a 50bp hike motivated simply by the desire to discourage markets from overly dovish expectations?

A: I’m not being tactical in that sense. Again, I said in March that I would not exclude that we have to go to 4%, and I always condition what I say on readings of inflation. Another bad reading for core would confirm what I’ve said a few times, that our models don’t capture correctly the persistence of inflation. And the more readings we have that confirm that, the more we have to accept that we might need to go there. And again, I step back and see that the US had to go to close to 5% to get this under control. I’m not saying we need to go to 5%. But on the basis of that, I do not understand how we could exclude 4% today. I don’t think you can exclude it.

Q: And why can’t an unpleasant surprise with respect to core inflation be considered to have been countered already by previous moves that simply haven’t had time to unfold their full impact? Otherwise, the risk of accidentally doing too much rises.

A: I’m not so sure, because again, it’s not like we’ve taken so many decisions since December. Probably if we had to redo the forecasts in December with the gas prices we have today, we would have expected core inflation below 5%. So, in four months, core inflation is close to 1pp higher than expected by the models. And this is a world where there is more persistence of inflation. And in a world where you have more persistence of inflation, I mean, you could say that if core is 0.7pp higher than in December, then it warrants going higher in terms of interest rates. Because the more inflation we have, the less restrictive our monetary policy is in real terms. On the lag, one can have a very sophisticated discussion about whether we want to go very high in terms of interest rates and then cut quickly, or stop at some point and stay high for longer. But the problem is that I don’t think we have the instruments to have sophisticated discussions about calibration of the one or the other when directionally we’re still not very confident that we have a good understanding of how persistent inflation is. A lot of people take comfort from expectations’ being still relatively well anchored, but my reading of wage developments is that it’s still a story today of recouping the losses of 2021 and 2022. Real wages have gone down quite a lot. And each reading of inflation that is a bit higher means that workers are going to want to recoup more, and that you’re going to have wage developments being incompatible with our 2% target for a while.

Q: So it’s prudent to err on the side of doing too much.

A: Let’s take a step back. When we had forecasts of inflation at 1.7% and headline at 4%, we increased QE. Now we have a projection that is above 2%, we have inflation that is still running very high and we have core going up. If you want to be a little bit symmetric, it implies that we might have a little bit more to do. After two years of inflation running at very high levels, with projections remaining above 2% for a relatively long period, there is a risk that at some point you’re going to see a dis-anchoring of inflation expectations, at which point it’s going to be too late. So, erring on the side of a robust rate increase that will keep inflation under control makes sense. Of course, we all aim for a soft landing. No governor is going to say that we need to be extremely forceful to be sure in any scenario that we return to 2% immediately or very fast. We all want a soft landing. I’m never going to be pleading for erring on the side of being extremely conservative so that we are sure to return to 2% in all circumstances. But after two years of inflation running at very high levels, I think the idea that you have to be on the safe side is reasonable.

Q: You called for the ECB to do more on quantitative tightening. Would you agree with your colleague Governor Šimkus that ending APP reinvestments from July should be an option?

A: I’ve supported that. We’ve been very clear that we wanted to be very cautious, because we didn’t want to enter into QT and then have to go back. So, we started with something that was extremely cautious, the €15 billion per month. The idea was always that we would see whether there is anything in the market that we could not have predicted in terms of absorption capacity and so on. The idea was never to stick to €15 billion per month. The idea was always: “let’s test it and see how it goes”. And it’s going well, so we should be doing more. Whether in July or whenever, it’s going to take years in any case. But that’s all the more reason to not wait too long. On the basis of what I know today, ending APP reinvestments from July would be reasonable.

Q: And when would you want actual sales to occur?

A: The way you pose the question implies that I would want sales to occur at some point, which is not the case. The base case is that we would not go for sales, and that remains my base case. What can be discussed now is stopping reinvestments, and after the APP we still have the PEPP. I’m not looking beyond this.

Q: What about changing the guidance related to the PEPP?

A: I would go step by step. Let’s have a discussion about the APP, and then we might want to reconsider the PEPP at some point.

Q: Still, from today’s perspective, continuing to reinvest PEPP principal payments until at least the end of 2024 seems a bit much.

A: If we stop APP reinvestments sooner rather than later, then I think at some point we will have to have a discussion on that. Whether it means we reopen it or not, we will see. I don’t want to pre-commit on that.

Q: Do you see any kind of a trade-off between rate hikes and doing more on QT?

A: There are trade-offs. Whether we can really have a very fine understanding of precisely what the impact of one versus the other is, I’m afraid the models are not that trustworthy. We are working on QT, which can have more impact on the spreads - and from there potentially on transmission – than working on interest rates. I said at the ECB Watchers Conference last month that we have been confronted with a weak form of fiscal dominance in Europe for too long. It’s not that I want to test it, though. So far, spreads have been very well behaved. I’ve always supported the TPI very much. If a widening is unwarranted, we need to be able to react. So, I would not go and test the markets’ absorption capacity. I think if we go too fast on QT, we could be faced by some technical constraints that we had not seen but that could impact spreads. Why should we go for that? So, I think that the idea that we want to be on the safe side with respect to QT so as to preserve the quality of transmission is quite consensual. And we’ve communicated quite strongly that we want to be on the safe side on QT, which probably means that our main instrument is the interest rate.

Q: What about QT being part of a possible policy compromise in the sense of doing more on the one front and less on the other?

A: In principle one can always have that kind of trade-off, but I would not be pushing to do more on QT and less on rate hikes.

Q: And if you felt strongly about the need to do 50bp in May?

A: The thing about QT is, we did QE because inflation was too low. Now, inflation is not too low anymore; it’s too high. So, QT is a no-brainer. We need to reduce our balance sheet and we’ll have to reduce our balance sheet in a way that is going to take years – fast enough for it to go down, but without creating any market tensions. So, to me it’s not a side discussion, but I would not want to mix that discussion too much with the rate hikes, which are the main policy instrument.

Q: So, you wouldn’t want QT to be part of a possible May compromise on the hike size, or a later compromise on where to stop hiking, if the burden can be shifted to QT?

A: I don’t think it would be a healthy compromise, because we all agreed that we need to do QT, because our balance sheet is too big now compared to where it should be, considering that we have too-high inflation. If there were to be any kind of artificial trade-off or negotiations around QT versus rate hikes, I honestly don’t think this would be an interesting discussion.

Q: Where would the balance sheet ideally be?

A: That’s the discussion we will need to have at some point on whether we want to go back to the corridor system or instead go to a floor system. There are advantages and disadvantages to both. My view is that the burden of proof is on the side of those who want to go to a floor system. Because the corridor system did work, and my basic assumption is that our footprint in the market should be as limited as possible. Otherwise, it creates a lot of issues in terms of what we invest our balance sheet in, and it reduces our room for manoeuvre, because we would always start from a bigger balance sheet. But I think there is another argument that some have made already, namely that we see now that retail deposit rates are not moving in line with the DFR, which is normal, because banks have taken positions by lending at relatively low rates, so they cannot afford to move with the DFR. But this invites difficult questions about why we pay the DFR to banks when the poor depositors don’t even get 1%. There is a real risk that this is going to become a relatively toxic discussion in some countries. So, I would want to avoid that, and that’s one reason why I think that the burden of proof in terms of the floor system versus a corridor system should take some of those arguments into account.

Q: Until this discussion takes place, there’s no reason for the ECB to worry about the spread between the key interest rates.

A: One can always think about a compromise between the corridor system and the floor, but I would not like to introduce more detailed discussions before we have a discussion of first principles. The corridor system worked, and I think even in the Treaty there is an assumption that we would base our monetary policy on the working of a market economy, which to me means that we should not have a footprint in the market that prevents price discovery from functioning.

Q: A number of your colleagues, including Banque de France Governor François Villeroy de Galhau, now say the ECB is almost where it needs to be. Do you think there is any chance that the ECB will confirm this formally after the May hike?

A: We’ve done most of what we have to; again, we are not going to do another 350bp. But confirming this without being more specific would, I think, create more confusion than anything, because on the basis of what we know today- we see market expectations at 3.75%, headline inflation is going down and we can hope that core is going to go down at some point – so it’s reasonable to say that the discussion today is probably taking place between 3.5% and 4%. But we’ve been surprised in the past, and we can be surprised in the future. And again, the US had to go to close to 5%, and we now have stronger inflation dynamics in Europe. So, I would not today say that the discussion is in any case going to remain between 3.5% and 4%. I would not commit to that. And then, we have decided to go meeting by meeting. By confirming that we are almost done, we would be introducing another form of forward guidance that I don’t think would contribute to a good understanding of the situation. I also think it would suggest that uncertainty is lower than it actually is. Because you cannot exclude a new shock.

Q: Independent of where the terminal rate will turn out to be, would you at least endorse the view that we should reach it by the end of the summer, which includes September?

A: Again, I don’t know, because I don’t know what’s going to take place. If nothing happens and everything develops as we thought, so if energy prices evolve in line with the projections and if there are no shocks that we failed to predict, then it’s likely indeed that it will be the case that we should be there by the end of summer. But I don’t know.

Q: Of the various factors that have been mentioned as influencing the May decision, is there one that dominates your own thinking?

A: I tend to look quite a lot at core inflation, because I think that as of today, it’s the best information we have in terms of the extent to which inflation is more persistent than in the models. We know that the models tend to converge quite quickly to the objective, and models have not been performing well over the last two years or more. So, I use it also as an indication of the performance of our models in terms of the projections. And the other thing that I think is really bringing a lot of value into the discussion is the tracking of wage developments, because this is really a forward-looking indicator that is maybe not in line with what the models would predict, but I would have more confidence in real information about new wage agreements that are being signed than in what the models would predict, given the catching-up workers want to happen. It’s normal for workers to want to be compensated, but if this takes place too fast, it’s going to lead by itself to added resistance as we try to reach 2%. And I have no doubt that inflation is going to go down. But I think we have at least some early information on the possibility that it could face some resistance somewhere between 3% and 4%.

Q: And with respect to wage developments, have you seen anything alarming?

A: It’s not alarming, but at least in the coming quarters and probably for the next year or two, it’s not compatible with going back to 2%. On average, what we see in terms of wage developments probably over the next two years is not really compatible with our 2% inflation target, and to go back to 2% with the wage developments we are seeing over ’23 and ’24, we would need margins to go down. And firms have market power, also because of labour shortages.

Q: And do you have a preferred indicator of wage developments?

A: There’s this Irish tracker.

Q: Is that the one that looks at wages in job ads from six Eurozone countries and the UK?

A: Yes. They’re trying to extend it. And of course, in June we will have a bottom-up, full macroeconomic projection exercise, and then we will have more information. And it’s not only about wages.

Q: In view of last month’s turmoil in the banking sector, the ECB considered pausing on March 16. And yet here we are discussing the possibility of another 50bp hike. To what extent is that turmoil still in the back of your mind and associated with concerns about possibly triggering a negative reaction?

A: First, I want to be clear. I’m not defending 50bp, I’m just saying that the discussion will be between 25bp and 50bp, and I see arguments for going one way or the other, and so it will depend on the data. On the banking front, what we see is comforting. We have a strong banking system in Europe. Liquidity buffers are high, capital buffers are high, we’ve seen some return of confidence, so the idea that there would be a lack of trust in the system seems to be receding. So, again, I think in the US the question is how big the impact is going to be on credit restriction, because most probably, some banks will have to rebuild buffers. In Europe, you don’t have a need to rebuild buffers. So, you might have issues of trust, of caution in the banking system that would lead to more restrictive financing conditions, but we don’t see a reason for why that would necessarily be the case. So, I would certainly not exclude that the impact of what we’ve seen in the US and in Switzerland would be limited in the euro area, and even to the extent that there’s not an impact on our monetary policy. I’m not saying it won’t impact, but the case where it doesn’t impact or has a very limited impact is certainly not to be excluded.

Q: We’ve seen the euro appreciate lately; that’s helping, no?

A: It is, but there’s a lot of lag in the transmission of the exchange rate to inflation. We had a big appreciation, which has been to some extent undone. I’m not even sure, if you look at the impact of last year's depreciation and the impact of the appreciation more recently, what the net impact would be on our projections, because the lags are quite long. But yes, directionally, it should help.

Q: If it were to appreciate further, might that influence the desire to tighten policy?

A: It would probably influence the projections.

Q: And what about competitiveness concerns?

A: That’s not our mandate as such. We should focus on our primary mandate of price stability. But of course, a stronger euro should contribute to lower inflation.

Q: Is it the case that something between 25bp and 50bp is a non-starter?

A: I don’t think it’s on the table. Again, the markets expect a terminal rate of 3.75%, and there are other ways to convey a message. You can have a dovish 50bp or a hawkish 25bp, so there are many ways to express where you want to go other than going for a move which would be an average of the two main options.

Q: Under what circumstances might a pause make sense to you in this tightening cycle, not necessarily in May but rather in general?

A: In general, I think if we were to see core inflation going down at a significant pace, not like 0.1pp every three months. And of course, we would need a number of readings of core going down, and I’m talking about monthly data, not the year-on-year reading, which to a large extent is the result of what we’ve seen in the past. But if the momentum of core inflation would go down to numbers that are clearly going in the direction of our 2% target, then at some point this is going to argue for a pause. But I think that given the persistence that we’ve seen in inflation, we would need some confirmation of this over a number of months; one or two readings won’t do it. So, pausing is one of the options that we always have in terms of policy-making, but as long as core is as sticky as it is and growing with a momentum of around 0.4% on a monthly basis, this is not compatible with our objective.

Q: Let’s say we hit the terminal rate in June, which seems entirely possible. Why should a rate cut in December, a whole six months later, be impossible in this case?

A: Given the uncertainty about inflation developments and the shocks that could be coming between now and the end of the year, I would not exclude anything. We were in a situation where we had some catching up to do and we gave some forward guidance, because we knew we had to do a lot more. Now we are in a situation where, on the basis of what we know today, it might be about just a limited number of rate hikes, or not. There are many scenarios; you might go to 3.75%, remain there for a while, and then, if inflation is going down faster than you thought, you might have to cut rates. Or it could be that 3.75% is not going to do it, and you have to do more. I would not exclude any of these possibilities.

Q: Are you leaving Washington with a sense of optimism or pessimism about global economic developments?

A: Broadly speaking, our economies have been much more resilient than we thought. We thought we would have a recession last year in Europe. Labour markets are extremely resilient. The excess savings of the Covid period have not been spent. They might have been invested, but they haven’t been spent. So, all that has been essentially good news. The solidity of the financial system has maybe surprised us from the other direction. Basically, having banks fail in two days is an issue. I take some or a lot of comfort from the fact that authorities in the US and Switzerland have clearly excluded a Lehman moment. They didn’t want to play with fire and they have taken measures to avoid an unravelling of the system. I think the fiscal positions in Europe and the US are strong enough to allow for that.

Q: You mentioned again the strength of the labour markets. Do you think in Europe they will have to weaken significantly for you to get inflation under control?

A: I don’t think it’s going to be inevitable, and I hope we are not going to have to see a pickup in the unemployment rate to get inflation under control. At least, it’s not what our models tell us. Our models tell us that we can get inflation back to 2% without an increase in the unemployment rate. Our models have not been performing extremely well, but at least there is a path. And again, what we aim for is a soft landing. Whether we can get a soft landing is something that we’ll have to see.