TRANSCRIPT: Interview with ECB Governing Council member Kazāks on 26 June 2023

28 June 2023

By David Barwick – FRANKFURT (Econostream) – Following is the full transcript of the interview conducted by Econostream on 26 June with Mārtiņš Kazāks, Governor of Latvijas Banka and member of the Governing Council of the European Central Bank:

Q: Governor, it’s very clear that a hike is coming in July, but it’s starting to sound like we might get yet another one in September. Do you anticipate that in five weeks, the ECB will make a statement about September equivalent to last week's about July, i.e. that "barring a material change to our baseline, it is very likely the case that we will continue to increase rates in September"?

A: I think we still have to hike in July, and in my view we still have to hike further post July, perhaps also in September. Uncertainty remains elevated, so any forward guidance has to be extremely cautious and not look too far ahead. That said, inflation is still high and is projected to remain high, with risks clearly on the upside. So, from today’s standpoint, interest rates are not currently restrictive enough and I think further rate hikes will still be necessary. But with uncertainty this high, our modus operandi of making data-driven decisions meeting by meeting is a very appropriate choice. We do see that monetary policy is working through the economy, leading to tighter financing conditions. However, we still have to see how this affects inflation. This is in the context of strong labour markets and the risk of sustained wage pressures. In the second half of the year, wage growth is likely to be above inflation, so that real incomes will start to recover, which could lead to yet more inflation persistence. There are many upside risks to inflation that argue for interest rates to go up higher into restrictive territory. Ultimately, we will see what we need to do in September, when we will also have new macroeconomic forecasts, in addition to the inflation readings that come out between now and then.

Q: Still, from today’s point of view, you think we won’t be done hiking in September.

A: I would say that we won’t be done in July. How many hikes and at what pace, we will see; uncertainty is very high. Yes, the economy is somewhat weak, and risks to growth are on the downside. But those risks, or the weakness in the economy as currently projected, is not sufficient to significantly weaken labour markets, which means that the drivers of wage pressures and labour demand are still going to be relatively strong, which may make inflation more persistent. So, if you have uncertainty about the baseline, then you look at the tail risks. In terms of monetary policy, one tail risk is doing too little tightening and running the risk of inflation coming back. The other is raising interest rates a tad too much and bringing inflation down quickly at the expense of economic weakness. However, it’s relatively easy to provide support for the economy by cutting rates. On the other hand, if you have not raised rates sufficiently, and inflation starts to come back, then we would need to hike even more. So, I still see that the risks of doing too little are higher than the risks of doing too much. In my view, therefore, rates still need to go up to deal with inflation in one go, so that we don’t see inflation coming back. Another point is that given all the uncertainty, the longer inflation stays significantly above 2%, the more we are vulnerable to other shocks that could push inflation up further. So, returning to our price stability target is very important to me.

Q: Does the high uncertainty imply that when we hit the terminal rate, we won’t know it for a while?

A: It’s not a pharmacy where things can be dosed exactly as desired. It’s always going to be a trial-and-error approach in my view, and we will know it ex post. Ex ante we can’t know, also because of the interplay of various other factors. The other thing is that it’s not only about hiking rates to a sufficiently restrictive level. I think that is important, but it’s also about keeping them at that level, and in my view, the rates should remain at high levels as long as inflation is not significantly undershooting the target, because we will need this policy space sometime in the future. Why should we start cutting the rates if inflation just converges to our target but does not undershoot it? By cutting rates we would provide stimulus and push inflation above our target. I think that when we climb to sufficiently restrictive levels, we should be spending quite a bit of time there.

Q: And when you say, “significantly undershooting”, you mean more than 0.2 point, I assume?

A: I can’t give a decimal amount, because it’s not only about inflation, but also all the other variables. For instance, there could be a situation where headline inflation comes down, but underlying inflation pressures remain high and continue to pose a risk of inflation returning, and then there is no reason to hurry and cut rates.

Q: But at some point next year, the time to cut will likely come.

A: We’ll see. Forward guidance at the moment is very risky. But if we look at what the markets currently expect, that rates might be coming back down already early next year, in the first half, this is simply inconsistent with the baseline macro scenario and goal of a timely return to 2%. Markets must be pricing in more negative macro scenarios or some kind of financial turmoil risks that would push inflation down quicker what we currently have in our baseline scenario.

Q: A July rate hike is baked into forecasts, since you use market rates. So the July hike is clearly not even erring on the side of caution, but rather is necessary. Would you expect the mechanical updates of the forecasts available in July to show that a September rate would also be erring on the side of caution?

A: We’ll see, but as I said earlier, I think that with the current inflation outlook and the current risks to inflation, we won’t be done in July and there will be more rate hikes necessary. And then we should be in no hurry to cut rates, because we will need that policy space sometime in the future. Only when we see inflation returning to 2% and with a high risk of falling significantly below 2% in a persistent manner, I would see the need to cut rates.

Q: And are you hoping that we will be done hiking in September?

A: Let’s see what happens in September and afterwards. There are so many moving parts that it’s difficult to say. I think more rate hikes will be necessary, given current information in terms of the economic outlook, price pressures, the strength of labour markets, corporate profit margins still being quite resilient and so on. We will not be done, in my view, in July, and there will be more rate hikes necessary. In September we’ll see what happens in September, and in October we’ll see what happens in October. If necessary, we can take a pause and then return to rate hikes. Let’s see what the data tell us.

Q: We are going to get a marked increase in German core inflation driven by base effects for the next three months. Is this a threat to the anchoring of expectations that would help justify more tightening, or can we look through it?

A: So far, looking at standard measures of market-based inflation expectations, we are still in a quite comfortable situation. Expectations seem to be well anchored, although we see some increase. We should not risk inflation expectations dis-anchoring, because it would make our job to restore price stability so much more difficult. At current levels, of course, inflation already does affect decision-making, both for corporates and households. That is, they pay attention to inflation in their decisions. And that is not good, because that can contribute to inflation becoming even more persistent. In terms of inflation expectations as such, I would say so far, so good. We have to monitor that, but the sooner we get inflation back to the “area of inattention”, the better.

Q: How comfortable were you with the outcome of the projection exercise this time?

A: I think there are always questions about the forecasts. One has to take them with a pinch of salt, remain sceptical and always think “what if?” That’s why I mentioned – and in this I very much agree with the forecasts – that risks to growth are on the downside and risks to inflation are, unfortunately, still on the upside. And this is what I think the markets are currently getting wrong when they think that rates would come back down so quickly. We very clearly see in the forecasts that even in 2025, inflation is still going to be somewhat above 2%, which is simply a very long time period. It would be more appropriate to expect rates to stay at restrictive levels for longer. And that would also provide more monetary tightening and therefore help bring inflation down. Also, it’s not that monetary policy is the only game in town. Fiscal policy has to become restrictive. If fiscal policy remains too expansionary, it only means that interest rates will have to go up more, and that of course may entail financial stability risks.

Q: The Council has displayed up to now a remarkable degree of convergence. Some observers are expecting this to come to an end. Could it be harder beyond July to reach consensus?

A: We’ll see. So far, so good. Our decisions this far have been very broadly supported and I think we’re on the right track. There will always be discussions, but I think such discussions are necessary and important to avoid groupthink.

Q: When would you want the ECB to engage in actual sales of assets?

A: That is still to be discussed. Currently of course we still have the PEPP reinvestment, and that is also important for flexibility reasons. As for APP, we are poised to stop reinvestments from July and in due time we may start active sales, but not yet.

Q: Are you in any hurry to start active sales?

A: Not at the moment. The balance sheet adjustment is very much driven by the TLTROs. That’s the largest element that will trim the balance sheet this year.

Q: What about at least just changing the forward guidance with respect to the PEPP?

A: In my view, there’s no need for any changes to the PEPP reinvestment at the moment.

Q: You are not in a rush to accelerate QT. Is this because you’re focused on the interest rates as the main tool?

A: Interest rates are the main tool currently, but of course balance sheet reduction does go on in the background. One reason for this is forward-looking: to use the balance sheet as an instrument, one needs to free up policy space. If we do return at some point to the lower bound, then the balance sheet is one of the instruments we may need to use. And for that of course it would be necessary to have the policy space. That’s point one. Point two is the market principle: if we can avoid having a market footprint, then we should do so, exiting those assets gradually so as not to disturb market operations. Point three is the yield curve. All three elements are important, but currently the most important instrument to drive down inflation is the interest rate.

Q: You indicated a willingness to return to QE in the future if we get back into a situation of low inflation, but is the willingness to use QE again lower as a result of the previous experience with it?

A: The question is not so much the willingness to use QE, but the necessity of using the instruments at our disposal. We do see that those instruments can be quite effective, but I think in many cases there’s still more research to be done to see exactly what the pros and cons are of balance sheet policies, what the possible trade-offs are, so that the next time we may need to use it, we will be better equipped. I think it would be nice to go over these things before the next strategy review and to see how effective those elements really are and what other options there are in terms of the balance sheet.

Q: A decision yet to come is whether the ECB should rely on a floor system or a corridor system. Are you leaning in any particular direction?

A: We will discuss this and then see. I think it’s very clear that the balance sheet is big enough and excess liquidity will remain there for quite a while, so there is no rush to take the decisions. But when we can decide, be it at the end of the year or later, that would be fine. And there are many possible variants.

Q: What is currently at the forefront of your mind in terms of policy, just to make sure we didn’t miss anything?

A: The important thing in my view currently is that we should be in no hurry to lower interest rates unless inflation is significantly and persistently at risk of undershooting 2%. Why should we? We need the policy space.

Q: What about the argument that most of the impact from 400bp of tightening is still to come?

A: Sure. That is in my view the argument of how high we climb with rates, and that’s one of the reasons why we have slowed the pace. Because if you start to approach the peak level, perhaps you should stop. In my view we’re not there yet. But we’ve done quite a lot, and there is quite a lot in the pipeline of course. That will all work through the economy. But what I am saying is that it does not necessarily mean that as soon as we see very credibly that we are at 2%, we should start cutting the rates. I think we should start cutting the rates when we see that we are likely to undershoot 2%, so that we can ensure that inflation is around 2%. That’s a symmetric target; it’s about being significantly above and then being significantly below. That is my view. We should not hurry to lower interest rates only because we have reached 2%. Why limit policy space that was so hard to obtain? So if inflation declines to 2% and is expected to stay there, why should we cut rates?

Q: As soon as the forecasts show 2% stably reached, a lot of Governing Council members will start wanting to ease policy.

A: Maybe. Currently I’m not one of them. Of course, at the end of the day, not all decisions have to be made unanimously. A majority is enough. So far, the president has been very skilful in getting almost all of us behind every one of our decisions. She’s done a terrific job and I have no doubt that she will keep doing it in the future.