TRANSCRIPT: Interview with ECB Governing Council member Herodotou on 15 January 2024
15 January 2024
By David Barwick – FRANKFURT (Econostream) – Following is the full transcript of the interview conducted by Econostream on 15 January with Constantinos Herodotou, Governor of the Central Bank of Cyprus and member of the Governing Council of the European Central Bank:
Q: Governor, you said on 11 October that "economic growth for this year is going to be subdued, but we are avoiding a recession or any prolonged downturn". Have you grown more pessimistic?
A: The latest incoming data points to a weakening in economic activity in the near term. A small GDP contraction by 0.1% q-o-q was recorded in the third quarter of last year, and short-term indicators suggest weak economic activity in the fourth quarter of 2023. However, growth is expected to strengthen from early 2024, as real disposable income rises due to declining inflation, wage growth and resilient employment, which should support confidence and consumption, as well as due to export growth catching up with improvements in foreign demand. According to the ECB December 2023 forecasts, GDP growth is expected to slow down from 3.4% in 2022 to 0.6% in 2023, and recover to 0.8% in 2024. So, it is fair to say that I have not grown more pessimistic since the September forecasts and any contraction in the economic activity in the euro area in the near term is expected to be shallow and short-lived.
Q: Did the ECB go too far with its policy tightening, and do you agree that putting things on hold all the way until 2024 wage developments are clearer - next April or May - is excessively long under the circumstances?
A: The approach to determine the appropriate potency and duration of the restrictive monetary policy with the aim to timely bring inflation back to its target is data-driven, meeting-by-meeting and not time-driven. In this respect, the policy decisions so far, are providing the desired outcome. The past rate increases continue to be transmitted to the economy. Tighter financing conditions are supporting the continuous disinflationary path, which is now expected to reach the 2% target in 2025. All measures of underlying inflation declined in October. Negotiated wages in the euro area exhibited a high annual rise of 4.7% in the third quarter of 2023. In addition, many wage negotiations in the euro area will take place in the first half of 2024, thus an important element for the ECB’s monetary policy analysis still remains unknown. Therefore, it is warranted to remain very attentive to wage negotiations’ developments in the coming months in order to have a clear picture on these underlying dynamics and further inform policy actions going forward.
Q: If economic weakness became more pronounced or it became obvious that euro area labour markets were already weakening, would it still be necessary to wait six months to see 2024 wage growth, or could you reasonably conclude sooner that inflation will sustainably continue to decline?
A: Our mandate is price stability, and inflation must be brought down to its medium-term target of 2%. I believe it is important to take a holistic view when assessing the economic situation and the outlook for inflation by looking at information from various surveys as well as from various data sources and indicators, among which are wages. Having said that, wage developments may currently warrant more attention given the staggered and often multi-annual nature of wage setting processes in the euro area labour markets, in light of possible stronger upcoming wage demands by workers, in order to cover for their income losses of the previous years due to high inflation. Therefore, a comprehensive assessment of the broad economic situation should be performed in order to conclude that inflation will sustainably continue to decline to the medium-term target.
Q: Do you fear any sticking points in the disinflation process?
A: Following a normalisation in energy prices and stronger-than-expected transmission of the monetary policy, inflation in the euro area has been on a downward trajectory since November 2022, especially in the last months. As anticipated, December 2023 headline inflation is expected to rebound to 2.9%, up from 2.4% in November 2023, related predominantly to upward base effects in the energy component and the reversal of some fiscal support measures. That said, the overall disinflationary process is expected to continue over the medium term. According to the ECB December 2023 projections, inflation in the euro area is expected to fall further at 2.7%, 2.1% and 1.9%, in 2024, 2025 and 2026, respectively. But there are some risks that could delay this path. Energy prices remain a major source of uncertainty amid the impact of fiscal measures and heightened geopolitical tensions, even though the effect of the conflict in the Middle East on energy inflation has so far been muted. Food prices could also come under upward pressure due to unfavourable weather events and the unfolding climate crisis. At the same time, the disinflation process could be derailed if wage pressures or profit margin dynamics move in a different direction than expected. Conversely, potential inflationary pressures could be eased by the softening of global economic activity, slowing jobs growth and other labour market developments or moderating demand from China.
Q: When would it be appropriate for monetary easing to start, based on what we know now?
A: Acknowledging that there is substantial uncertainty given the consecutive shocks to the economy, our policy decisions are calibrated on a meeting-by-meeting basis and by analysing the most recent economic and financial data at hand at the time of each decision. At this point, under the current juncture of the two geopolitical conflicts and the possible supply chain disruption through the rerouting of trade ships away from the Red Sea, any discussion of possible rate cuts would be premature. However, it is important to emphasise that inflation is now on the right decelerating path. Nevertheless, more time and further progress is needed to assess and conclude that this path is firm and sustainable enough to bring inflation back to its 2% target.
Q: Do you envision a sequence in which the first rate cut is flagged well ahead of time, or do you see the potential for things to happen surprisingly quickly (as with the hikes)? Does the delay of policy easing imply that it should start large, i.e. with a cut of not less than 50bp?
A: As I have already mentioned, the latest ECB projections show that we are on the right track and inflation shall average 2.1% in 2025. Looking ahead, further transmission from past monetary policy decisions to credit and the real economy is still in the pipeline. However, a lot more data shall be available during the first half of 2024, which are necessary for the calibration of future decisions. Any discussion regarding the time and potency of the first rate cut, as well as the pace of further cuts thereafter, would be premature at the moment and would not constitute a data-dependent approach.
Q: Where do you think the euro area neutral rate will wind up being?
A: With major central banks’ tight monetary policy stance currently in place, an important question is where policy rates will settle in the long run. The long-run neutral rate is estimated using various models with the most important drivers being the supply of sovereign debt, demand for safe assets, trends in productivity growth, demographic changes, and global spillovers. As this variable is unobservable, like all estimates, it is surrounded by a lot of uncertainty. For this reason, a wide range of estimates is needed for this analysis. Currently the range of the neutral rate estimates is well within the positive territory and certainly higher than in the pre-pandemic period.
Q: You are one of the few Council members not to have expressed a view publicly on the desirability of accelerating the process of QT. How do you regard the decision to cut reinvestments from mid-2024 and end them at end-2024?
A: I welcome the December decision on PEPP as I think it strikes a balance between complementing the restrictive monetary policy stance while safeguarding smooth market functioning and, thus, the policy transmission. It is important to have a smooth absorption of the accelerated reduction from our earlier decisions on the TLTROs and the APP, and this is what I expect as regards the latest decision on the PEPP. The Eurosystem balance sheet has moved noticeably from its peak over the last year and is moving in the same direction as our monetary policy stance. In addition, compared to pre-crises levels, the appropriate level of central bank reserves can be expected to remain relatively higher in the new steady state, and therefore the gradual balance sheet reduction makes sense in this regard. With these in mind, and on the basis of the available data to date, our stance on the pace of QT seems well balanced at this juncture.
Q: Euro area fragmentation has been limited for more than a year. How much of this is due to the mere fact that the PEPP could be deployed to counter fragmentation if it occurred?
A: Indeed, the level and movement of bond spreads indicate that fragmentation in the euro area has been avoided. By design, the PEPP reinvestment flexibility has been the first line of defence to counter risks to the transmission mechanism related to the pandemic and it worked extremely well, especially when it was mostly needed. Even at the current juncture, where there are no net asset purchases and PEPP’s remaining lifetime is limited, the programme’s flexibility is still in place and remains effective, however, its impact for the last year was more or less at the margin.
Let’s not forget that the Transmission Protection Instrument (TPI), has been in place for more than a year as the main long-term tool that can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.
Q: What are your thoughts about what the review of the operational framework should yield? Should any change in minimum reserve requirements wait for this review?
A: The review of the Eurosystem monetary policy implementation framework is progressing sufficiently. There are advantages and disadvantages, associated with all options currently on the table. Some features worked successfully in the past under scarce liquidity conditions, while other tools seem to be quite appropriate under the current economic and ample liquidity conditions. A careful calibration of all possible instruments and modalities that would serve better the framework’s objectives, including the appropriate size of the balance sheet, will take place. Part of this review should also be the role and parameters of the minimum reserve system. I believe it is important to ensure a framework that is operationally adaptive, flexible and robust and implements our policy stance efficiently and effectively.
Q: To the extent the ECB disagrees with financial markets’ rate cut expectations, does the ECB see the issue as a misunderstanding by markets of the ECB’s reaction function, or as exaggerated expectations by markets of how much the economy is going to weaken?
A: The ECB remains focused on a data-dependent approach, and ready to react to any changes in the macroeconomic environment. This data-driven approach allows us to observe developments at the macro level, and thus obtain all the necessary information before making a decision, without the risk of falling prey to noise. For example, while the November inflation release was more favourable than market economists expected, this was driven mostly by the energy component, reflecting base effects from last year. On the other hand, the December inflation showed an uptick, mainly due to upward base effects in the energy component and the reversal of some fiscal support measures, such as the reduction of government subsidies on gas, electricity, and food. Despite the different month-to-month behaviour, energy prices are expected to stabilize in the coming months. While the recent developments in the disinflation path are encouraging, more time is still needed before declaring any victory over the historically high inflation observed in the past two years. Until then, we need to remain cautious and continue to be data-dependent.
Q: Which will count more when you eventually consider whether to cut interest rates: increasingly weak credit developments or the growing weakness of labour markets?
A: The successive shocks have changed the economy in various ways. The sensitivity of the economy to various key economic parameters has been altered, something that cannot be ignored when setting policy. The pass-through of the monetary policy to credit developments has been strong, in fact stronger than in previous hiking cycles, while there is policy tightening from past decisions that has not been transmitted to the real economy yet. Having said that, despite the strong monetary policy tightening, the sound labour market dynamics have been cushioning its impact on the real economy, so a soft landing can be expected. Therefore, although labour market conditions may warrant more attention in our policy deliberations, as I have mentioned before, it goes without saying that the decision when to cut rates will be based on a more holistic and broad spectrum of parameters and developments.