TRANSCRIPT: Interview with ECB Governing Council member Šimkus on 17 July 2023

19 July 2023

By David Barwick – VILNIUS (Econostream) - Following is the full transcript of the interview conducted by Econostream on 17 July with Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania and member of the Governing Council of the European Central Bank:

Q: Governor, a month ago you expressed the expectation that in September, there would be arguments made for another rate hike. How do you stand on this now?

A: What we’ve learned since then is that the PMI indicators have become worse. Even the services PMI indicator deteriorated, and the composite measure was even worse. But on the other hand, we have the same robust labour market, we still see unit labour costs growing and the latest flash estimate for core inflation was marginally higher than a month ago. Yes, we see a clear trend of declining headline inflation, but inflationary pressures remain pretty strong. With the resilience of the labour market, upward pressure on core inflation persists. And the data are more or less in line with the outlook for real activity and inflation that we discussed in the Governing Council in June. So, I feel comfortable saying today that there is a clear need for another hike in July, and that a hike should be one of the options we discuss in September. And therefore, I would not be surprised if we continued to hike in September.

Q: And the fact that you would like to discuss the option leads me to think you would also probably support it, at least from today's point of view.

A: The fact that it’s appropriate to discuss it has to do with the fact that we are data-dependent and open-minded. And in September, we are going to have more data, in particular new macroeconomic projections. These are very important. We do show in our June projections a downward trend for both headline and core inflation, but both are still a bit above our medium-term target at the end of the projection horizon.

Q: The September meeting isn't for another two months, though, and you're probably going to see inflation and the economy weakening between now and then.

A: You mean headline inflation; I don't expect to see much weakening of core inflation. The economy is weakening, but this does not come as a surprise. After all, we have done substantial monetary policy tightening – 400bp is a significant change in the environment. And of course, this impacted financing conditions first, but the real economy is only affected in the next round, and wages and prices only after that. Yes, it's quite clear that interest rates are now closer to the peak. But the closer you get, the more discussions you have around the data and how to read them. So, our data-dependent, meeting-by-meeting approach is very important, and I'm open for a discussion. And again, I wouldn’t be surprised by a hike in September, but in the context of the current moment, all I can say with certainty is that we need another hike in July, and I don't think we will have such quick interest rate cuts as some market participants expect.

Q: How quick do you think cuts will come?

A: We need to get rates to the level that results in a sufficiently restrictive impact on the economy for inflation to get back to 2%. And then we need to remain there long enough to make sure this happens. I remember some market expectations that we might cut interest rates in this year already, or maybe in the beginning of next year. I don't find this a very plausible scenario unless we see some unexpected changes in economic activity or inflation. Life seems to be full of black swans, especially in the last few years, but if the economy evolves as we currently foresee, I would say we will remain in restrictive territory for longer than a lot of market participants expect.

Q: But aren't we already effectively at price stability? I mean 2.2% in 2025 is almost 2%.

A: I understand the point, but we need to take a more systematic, holistic view. Headline inflation was revised only marginally in our last macroeconomic projections, while core seems to be stickier and more entrenched. We had a substantial revision of core inflation, partly due to past surprises, but partly from expectations of faster unit labour cost growth. That brings us back to the labour market, which is robust, with unemployment at record lows. Those growing unit labour costs feed into core inflation. And then there are profit margins, which made a quite important contribution to inflationary pressures last year. With the decline of economic activity, this factor may lose strength. But still, it's another potential source of inflation, so we will see.

Q: And what if you look at China, where there are some concerns about actual deflation?

A: China and the US are other jurisdictions, and we're dealing with Eurozone inflation. The Eurozone as an economic jurisdiction is also big, and what's happening here internally is at least as important as what's happening outside the region. But the environment is full of uncertainty, of course, and the economy might do worse, or it might do better. What we’re trying to do as monetary policymakers is to find the balance of risks between doing too little and doing too much. History is full of examples that show that if inflation becomes entrenched in the economy, then it becomes much more costly to fight. So far, we’ve been quite successful in anchoring inflation expectations, but time is working against us. The longer you have elevated levels of inflation, especially in sectors people notice on a daily basis, like food, utilities and services, then you get greater efforts to compensate for the increase in prices. So, time is working against us, and at this point, the risk of doing too little is still higher than the risk of doing too much.

Q: About ten days ago, though, the latest consumer expectations survey of the ECB showed that consumers’ expectations of future inflation decreased again.

A: This decrease is one of the effects of monetary policy. It goes to what I said about our monetary policy being successful in terms of keeping inflation expectations anchored, and it reflects consumers’ confidence in the ECB’s ability to control the inflation. Imagine a situation where inflation stayed above 2% far into the future. Consumers might change their expectations then. Luckily, this is not the case. So, for me, what we are seeing makes me confident that we are doing the right thing and will get back to our target.

Q: And if we should discuss a 25bp hike in September, should we also discuss the option of a pause with the explicit possibility of continuing at the meeting in October as the closest alternative?

A: We make policy on a data-dependent, meeting-by-meeting basis. So, each time we come to a meeting, we discuss a hike and a pause. This is the main choice, since of course we’re not discussing a cut under the current circumstances. If we say in September that we are pausing, this does not mean that in October we would not discuss all the options again. As I said before, life is full of black swans, so I believe in the approach we have chosen, in being more agile and reflecting what’s happening around us.

Q: If I were to ask you ten days from now, so right after the July meeting, do you think now that it's possible that you would already say then that we might have to discuss another hike in October?

A: For me, it’s mainly about September's meeting, because that’s when we get new macroeconomic projections and see what happened during the summer, just before we enter a new policy phase. So, for me September is an important point.

Q: A kind of watershed?

A: Yes. And October’s meeting would presumably be very similar to the one we are going to have in July, in terms of taking place in an environment with less information than at the June or September meetings.

Q: How much of an impact from previous tightening are you seeing on the real economy so far?

A: The answer for me is very clear. We are definitely having an impact on the economy and on inflation. There’s no way around it. The thing is that, because of the complicated environment we’re operating in, the effects of tightening are not materialising in as clear a way as models would predict. Where we clearly see the effects of monetary policy is in the financing conditions. That's obvious. And in this regard, monetary policy tightening is also being transmitted to the demand components that are typically more sensitive to interest rate changes: housing, business investments, the consumption of durable goods. This is the reason we're seeing the weakening of the manufacturing sector, and of the quite resilient services sector. These are the effects of monetary policy. So, I started with financial conditions, where the effects are very evident. But we are aiming for inflation, and the impact on prices comes from the changed balance between demand and supply. This occurs with a certain lag, 18 months on average. What we see now in terms of subdued economic activity is also due in part to our monetary policy tightening. These effects should peak this year and then only next year will the peak impact be felt on inflation.

Q: Is it possible that the effects will unfold in a nonlinear way, so that all of a sudden you'll get a big impact?

A: I don't think the effects are unfolding in a linear way now. We should be clear about this to ourselves. Therefore, I think our agile approach – meeting-by-meeting, data-driven - is particularly important. Having less forward guidance and more of a conjunctural analysis is an acknowledgment of these non-linear effects.

Q: And do you see events so far corresponding to the baseline scenario of the last forecasts?

A: Broadly speaking, yes. However, the PMI data surprised me on the negative side, in particular the services PMI. But mainly in that the deterioration came earlier than I would have expected. On the other hand, we continue to have a robust labour market, with wages increasing. And this is an important contributor to the continuation of inflationary pressures. Then there are the profit margins, which one would expect to decrease, especially with weaker economic activity. But unit profits’ contribution to the GDP deflator increased from 2.5% in 3Q 2022 to 3.3% in 4Q 2022 and were almost the same at 3.2% in 1Q 2023. So, it seems that profit margins continue contributing to inflation. But I would say that we are broadly in line with the projections discussed in June.

Q: How important is it to get a soft landing, so to reach the peak of the interest rate cycle without taking a large toll on the real economy?

A: Our aim is to control inflation. The type of landing depends not only on monetary policy, but on all the effects of the various policies combined and what's happening around us in the external environment. Of course, when you hike interest rates, you ultimately have a dampening impact on economic activity. But you're not thinking along the lines of, “Okay, we might have too much effect on the economy, so let's do something different.” For me, 2% inflation is consistent with a healthy economic environment. And by this, I mean that if a central bank needs to press on the brake so hard that it causes a hard landing, then this implies that something about other policies is probably acting in opposition to monetary policy.

Q: Going back to the discussion we had earlier about the rate cuts, when the time comes, what will be your requirement for this to happen?

A: We need to see inflation - headline and core - credibly settling at 2% in a couple of years from now for us to start considering that maybe interest rate cuts are approaching. By “credibly”, I mean that we should not be surprised once again by sudden and significant changes in the wrong direction. But having said this, I will repeat what I said before: based on the current economic and inflation outlook and on the pressures coming from the labour market and the profitability of companies, I think that we’ll keep rates in restrictive territory for a sufficient period of time.

Q: There doesn’t seem to be much enthusiasm on the Governing Council for the idea of selling assets. Are you an exception?

A: We’re currently implementing monetary policy through our main instrument, interest rates, and quantitative tightening is a complementary measure. And given the euro area’s composition, we should approach quantitative tightening very carefully, measuring all the effects very carefully to avoid side effects. Also, it's important to acknowledge that major steps were already taken, starting with partial reinvestments in March and then the cessation of partial investments beginning this month. But when I take my thinking one level up, I have to say that the existing stock of assets is very high, speaking only of the APP. This conveys an accommodative monetary policy signal, whereas with interest rates we are already in restrictive territory. So, the question for me is how this is aligned, this big balance sheet alongside restrictive interest rates. Second, the significant accumulation of assets has adverse effects, hindering money market functioning and creating collateral scarcity. And lastly, we are effectively working in a floor interest rate system, which can be maintained at a much lower level of excess liquidity. So, acknowledging that we are reducing the portfolio quite substantially, by around €80 billion per quarter, and taking into careful account these considerations and an examination of the situation, assessing the financial situation of the markets, of the companies and of the overall environment, I think we should be open-minded. And depending on the economic situation, and on the inflationary developments, we could get back to a discussion whether we should do more on that front, referring again only to the APP, maybe in the beginning of next year. Other central banks like the Bank of England and the Fed have already started active selling.

Q: So, the PEPP for the moment should remain unchanged, including forward guidance in particular.

A: Regarding the PEPP, yes, I would say that any potential adjustments to forward guidance require careful deliberation, taking all the aspects into account. And what's also important from the perspective of the PEPP is that reinvestments serve as the first line of defense against fragmentation or transmission risk. But we have the APP and we could do more on that front first.