By Marta Vilar and David Barwick – VALLETTA (Econostream) - Following is the full transcript of the interview conducted by Econostream on 16 February with Alexander Demarco, Governor of the Central Bank of Malta and member of the Governing Council of the European Central Bank:
Q: Governor, what’s most likely to eventually knock the ECB out of its current good place?
A: Incoming information suggests that our projections are still on track with respect to inflation and growth. So, we're still in a good place, and if everything remains as it is, interest rates will be stable for quite some time. There are risks, but we still see these as quite balanced for growth and inflation. The issue is that uncertainty is high. That's why President Lagarde reconfirmed the meeting-by-meeting approach. With this uncertainty, you could have demand shocks that push growth or inflation lower, or you could have supply-side shocks that push in the other direction. That's also why we talk about full optionality. This means rates could go up or down or remain the same. When you have a lack of visibility and things can change quickly because of policy decisions elsewhere, you must constantly reassess. It would be nice to be predictable, but it's like driving in the fog: you have to watch the next meter or two. You can't look much further ahead.
Q: So, risks are quite balanced, but which deserves more attention? Low inflation?
A: January inflation came in a bit lower than we had expected. Headline inflation has been below 2% mostly because of energy, while inflation excluding energy is still above 2%, though it’s declining. The data on wage negotiations indicate that wage growth is now heading toward its historical trend, which is a good sign. We still need more information about wage drift, because that may have been a bit stickier on the upside, but at the last meeting we had no new information on that. Oil prices have also risen recently; they are now around USD65–70, while the projections were around USD62–64, so there could be some upside impact from that. On the other hand, there are downside risks. I don't want to put too much emphasis on January; it’s one month. But January surprised on the downside in services and in non-energy industrial goods. For services, I need to understand better what drove that downside surprise. For non-energy industrial goods, we've been seeing inflation largely return to pre-COVID patterns, but I need to see which components drove the January miss. One factor that could matter is China. The euro area’s trade balance with China last year deteriorated by about 18%, driven by both rising imports and a drop in exports. Even in my own country, a couple of weeks ago it was reported that a Chinese manufacturer is now topping car-sale charts in Malta. So, imports from China are growing, and that could put some downward pressure on inflation. That's something we need to monitor closely. On growth, the latest data have been better than expected. Even the European Commission's sentiment indicator has been at a recent high since 2022, which is a positive sign. But uncertainty is still very elevated, and that's not good for consumer confidence, investors, or banks. From the last Bank Lending Survey, banks' risk perceptions have increased and lending conditions have tightened slightly. That's something we need to look closely at if financing conditions tighten further. So yes, I can see there could be some more downside risks to growth, even though the data have been somewhat better than expected.
Q: You mentioned the importance of full optionality. The more the ECB emphasizes keeping all options open, the more it sounds like the next move could be a hike.
A: Full optionality means all options, and it could go in either direction. It does not mean that interest rates are necessarily going up. There could be downside surprises to inflation, and if that leads to a change in the medium-term projections— for example, if inflation remains consistently below 2%—then there could be arguments for another rate cut. The source of this uncertainty is essentially the weaponization of trade. But in my view, a rate cut may become necessary, but it will not address trade uncertainty. One of the more important points in our last statement was the need for structural reforms that increase productivity and competitiveness, because that’s what’s needed for growth.
Q: And when you said that a rate cut may become necessary, do you mean now?
A: No. With the projections on track, there's no motive for changing interest rates at this point. But we have to watch a number of things going forward, especially inflation. After the January reading, we have to see whether this was a one-off or inflation will continue to surprise on the downside relative to our projections. That would be more concerning. It was already envisaged that we would undershoot a bit this year but return to 2% in the medium term. Energy is driving a lot of this. However, energy prices have gone up since last month, so we may undershoot less than we thought. But other variables, like imports from China, could pull inflation down. So, we have to monitor the situation closely.
Q: How likely do you think it is that a rate cut is eventually going to become necessary?
A: It depends on how things develop. As far as I'm concerned, I don't see much scope for any change in interest rates for quite some time if things stay as they are. I think we're basically in a good place in terms of inflation and interest rates are appropriate.
Q: But can one say that the burden of proof for hikes is now lower than that for further cuts?
A: I wouldn't say that. I think the burden of proof is the same for both. It's true that, when you're at around 2%, further rate cuts are harder to justify. But moving up would also require evidence that inflation is expected to rise materially, which we don't see at the moment. That's why the full optionality statement is there: either way, we are ready.
Q: How do you view market pricing, which calls for the first hike around the middle of 2027?
A: At the current juncture, I really don't expect any change in interest rates unless the projections change materially, especially for the medium term. If that happens, then yes, we would need to reassess the stance.
Q: How much would inflation have to undershoot in early 2026 for you to be surprised?
A: If we start consistently undershooting compared to what staff projected last December. Of course, there will be revisions in March. But if, for several months, we are consistently below what was projected, that is something staff will factor into their projections. If they revise downwards and, for a prolonged period, the medium-term outlook is below 2%, I don't think that's something you can ignore.
Q: So, would you agree with the comment we had last week from Bundesbank President Nagel that inflation under 2% in the next few quarters wasn't a reason to be concerned?
A: It's already embedded in the December projections: inflation is expected to undershoot this year, but by 2028 it returns to 2%. We've also had some changes because of ETS II. That was pushed out by another year. But the medium-term projection for 2028 still showed inflation returning to 2%, so we don't see much reason for concern yet. It's not that we are back to the old days of “below, but close to, 2%.”
Q: What if inflation undershoots more than you expected in early 2026, but the March projections still show 2% for 2028?
A: Staff would have to explain why the short term changes but the medium term does not. Maybe it's just a short-term thing because of energy or other volatile components, and that's it. But we would need an explanation to assess whether it is reasonable that the medium-term outlook is unchanged. For inflation, there are two opposing forces at the moment. On the one hand, there is wage drift, which we still need to understand—whether it is set to continue or whether it will fizzle out. That can keep services inflation up. The recent rise in oil prices could also have an impact. On the other hand, there is the China factor, which could pull in the other direction. We'll have to see whether this changes anything. Only time will tell going forward.
Q: If you agree that geopolitical risks have intensified over the last weeks, wouldn't you have to agree that downside risks to growth have also increased?
A: Geopolitical risks were already very elevated last year, with uncertainty about tariffs. Toward the end of summer, uncertainty receded a bit after the tariff agreements, but it was still elevated. And in January there were other issues around Greenland. What I see now is a sort of acceptance that this is not going to go away. I don't think uncertainty has increased recently; it has remained elevated. But maybe Europe is now realizing that it is the time for action. There seems to be more resolve to push real reforms in the EU. In a way, maybe this was a wake-up call for Europe to get its act together. You cannot always rely on a third party. Nobody owes us anything; we have to do it ourselves. And I would not pin our decline in external competitiveness on the exchange rate. We have pushed for the euro to have a more international role. What has been happening in the US has created an opportunity for the euro—not to displace the dollar, because I don't see that happening, but investors may rebalance their portfolios. That is an opportunity, and the creation of a European safe asset could be part of it. The proliferation of high tech—AI, for example—and enhancing the skills of the workforce are important. Europe has an aging population, and the contribution of labor to potential growth will diminish in the coming years. So, we need stronger productivity growth to achieve higher growth rates. There's no way we can do it through demographics unless there's a huge wave of immigration, and that's a sensitive issue. The only way is to raise productivity through investment and technology and a more genuine single market. So, to your point about downside risks to growth: I don’t see a new recent jump in uncertainty, but risks remain elevated—and the right response is to strengthen Europe’s resilience and potential growth through reforms.
Q: How do you regard the appointment of Kevin Warsh as the new Fed chair?
A: It would be premature to judge somebody before he even starts his job. I trust that, like his predecessor, he will have one goal in mind: achieving the mandate the Fed has been entrusted with. So, let's wait and see how he acts.
Q: Returning to the high uncertainty—given how bad it is for business and consumer confidence, doesn't it make you want to ease policy a little bit?
A: Easing policy to address this kind of issue might help a bit, but I don't think it's the solution. To address weaker growth or weaker competitiveness, you need structural reforms. Lower interest rates than at present on their own are not going to help you export much more.
Q: To what extent, and when, will the rise in Chinese imports feed through to inflation?
A: That’s very hard to quantify. I know for sure staff, in preparing the projections, were very aware of this issue. Whether what they factored in was enough, we'll have to see over time. We need an in-depth analysis to see where we underestimated inflation with respect to non-energy industrial goods and services. It's not easy to quantify how big the China effect will be. But we are certainly seeing increased market penetration by Chinese goods in Europe; that shows up in the data. And their goods are usually cheaper, so there will be an impact on the price level. I'm looking forward to the next projection round, because I'm curious to see how the projections will change, if they change at all.
Q: But you see a high probability that the projections underestimated the impact of Chinese imports?
A: It could be. But that doesn't mean the inflation projections will be lower, because there are other issues that could pull the other way. It's difficult to say at this point whether inflation will be revised downwards. But certainly the China factor pulls in one direction, and that could be a risk.
Q: On the exchange rate: the euro has appreciated sharply versus the dollar recently. Do you see this trend more as a worry, or as an opportunity for the common currency?
A: In the projections we had USD 1.16 embedded. Now it's around USD 1.18, which is not a big change. Past studies suggest an equilibrium exchange rate could be around USD 1.20 to USD 1.25, and there is still some way to go to that level. And even if we reach it, it's not the end of the world. But big movements are certainly something to monitor. It also depends on what is driving the appreciation, which seems to be not so much from Europe but from the other side of the Atlantic. If the euro becomes a more internationally accepted currency—either for reserves or trade purposes—that is a welcome development. If that brings an appreciation, then we have to roll up our sleeves and improve our competitiveness. If you want the euro to have a stronger international role, some appreciation is a possible byproduct.
Q: And speaking of competitiveness, wage growth seems to be an issue of disagreement.
A: From the data we've seen so far, wage growth—particularly negotiated wages—is moving toward its historical level. It's clearly slowing down. We've also seen some easing in the labor market. Employment growth is slowing, but unemployment is still very low. The labor market is still very strong. The key question relates to wage drift. We need to see whether it remains strong or fizzles out. You can have pockets of the labor market that are tight, which can lead to higher wage drift. But for negotiated wages, the growth rate seems to be heading down toward historical levels. I'm not seeing stickiness or persistence in wage inflation. If labor market conditions soften, wage drift will likely go down as well. I'm also curious about the underestimation of services inflation—whether it came from labor-intensive components or something else—because that could signal whether there are signs that wage inflation is coming down. From our contacts with Maltese businesses, they still highlight that labor shortages are acute and limit their potential to grow. However, they have also reported that wage pressures have eased. I think in the rest of Europe it's pretty similar.
Q: The German fiscal impulse is embedded in the projections, but what if there’s a delay?
A: When staff make projections, they have very strict rules. They can only factor in approved fiscal plans. So, if approved fiscal plans envisage that certain expenditures will take place in 2026, 2027, or 2028, that is what they embed. If there is a postponement, then they would revise their projections. I don't know the risk of a delay, to be honest—I am not an expert in German fiscal policy. But if there are delays, then of course there could be an impact on growth. As far as I recall, the projections show the euro area's fiscal deficit rising from 3% to around 3.5%. If there is a postponement, the fiscal impact on growth could be pushed further out into the future. And we would have to see whether that would have any impact on the path of inflation.
Q: Next Generation EU funds expire this year. How confident are you that German fiscal spending will provide net growth stimulus and not simply replace the support from NGEU funds?
A: According to the budgetary plans, there is planned fiscal expansion overall in the EU. Of course it will not be for all countries, because some countries will still be reducing their fiscal deficits. My country is one of them—though being very small, we don't influence the euro area average. But a number of countries are on a declining fiscal path, and hopefully France as well.