By David Barwick – NICOSIA (Econostream) – The passage of time is working against the European Central Bank on inflation as elevated oil prices persist, increasing the importance of pre-emptive action even though the September decision remains open and data-dependent, according to ECB Governing Council member Christodoulos Patsalides.

In an interview on Tuesday with Econostream (transcript here), Patsalides, who heads the Central Bank of Cyprus, said that no evidence had favored raising interest rates at last week’s meeting and that the Governing Council had therefore been right to leave them unchanged.

“There was no evidence that would have supported a rate hike. Second-round effects are not evident; expectations are anchored. So far, inflation is more or less in line with its expected path. In fact, the last figure came out a bit lower. So, there was no real reason to decide to hike,” he said.

However, Patsalides said the inflation outlook was subject to increasingly pronounced upside risks as the Middle East conflict continued and elevated oil prices had more time to feed through to other goods.

“The passage of time definitely works against us on inflation, in that higher oil prices may filter into other products, which could lead to generally higher prices,” he said.

“So, it is not unreasonable today to say that if this continues, the risk is further to the upside,” he said. “The risk accumulates.”

Patsalides was responding to a question about whether he shared the view of ECB Governing Council member Peter Kažimír, who said Monday that he would need very convincing evidence not to support another hike in September.

Patsalides was clearly unwilling to go that far, stressing that geopolitical developments remained unpredictable and that the September decision would and should depend on the evidence available at the time.

He said that while the outlook was now nearer to the ECB’s baseline scenario than to the alternatives, this did not in itself offer a firm indication of the next interest rate decision.

“In terms of the scenarios, it is nearer to the baseline scenario than anything else. But that does not say much to my mind, because the scenarios themselves could change or be updated,” he said.

Nor did the inclusion of further rate hikes in the yield curve underlying the ECB’s projections create any obligation for the Governing Council to deliver them, Patsalides said.

“Of course not,” he said when asked whether the hikes embedded in the forecast constrained the ECB.

He cited what he called an exaggerated hypothetical in which oil prices fell, there was no evidence of pass-through to the broader economy and global growth slowed, leaving no reason to raise rates.

By then, he said, the yield curve itself might have changed shape.

“One cannot be dependent on today’s yield curve,” Patsalides said.

Patsalides repeatedly emphasized that he had not made up his mind about September and did not know what evidence would be available when the Governing Council next met.

“In September, we do not know what data we will have,” he said.

The data of greatest interest would include evidence of second-round effects and the progression of the energy-price shock through oil-derived goods, input prices, consumer goods, inflation expectations and, eventually, wages, he explained.

Patsalides said he was closely watching the crack spread and purchasing managers’ indexes as part of that process.

“The price of oil has gone up. The prices of oil-related products have gone up. Costs have gone up. The PMI is up. That is where we are,” he said.

However, those observations reflected only the current situation, he said, and the Governing Council would still have to determine how the shock was propagating through the economy and what it meant for inflation over the medium term.

At the same time, Patsalides indicated that policymakers could not necessarily wait for every second-round effect to become clearly visible before acting.

“One needs to be ahead of the curve. The question is whether one should act pre-emptively,” he said.

The June rate increase had not been merely pre-emptive because the available data had justified it, he reasoned. The September evidence was not yet known, but the relative weight placed on pre-emption was increasing as the inflation risk rose, he said.

“The balance between the evidence we have and the value of being pre-emptive is shifting as the risk rises,” he said. “For example, given prices have been higher for some time, there may be some filtering into parts of the economy not easily observed.”

Patsalides added: “So, as more time passes without a resolution of the situation, and prices remain elevated, being pre-emptive gains in importance.”

The focus on oil did not mean that energy prices had replaced the ECB’s wider reaction function, Patsalides said.

The Governing Council continued to examine all three pillars of that framework, but other components, including the monetary-policy transmission mechanism, had changed very little since June. It was therefore natural for oil to dominate more of the current discussion.

“The oil price has gained importance out of necessity, not because our discussion or focus has become narrow,” he said.

On domestic inflation, Patsalides said he saw little evidence of cost pressures outside energy and no sign at present that wage dynamics were amplifying the shock.

“With the exception of energy, gas and oil, I am not seeing cost-push inflation. On wages and the wage trackers, there is nothing there,” he said. “If anything, my impression is that wage demands are contained.”

The more notable domestic risk came from fiscal policy, particularly as European governments sought to increase defense expenditure despite having limited room in their budgets, Patsalides said.

“Given the political situation in Europe and the need to boost defense spending, this is something that could potentially give rise to inflation,” he said.

“It could be a difficult situation because, as I mentioned, there is no fiscal space. This could lead to something very difficult to manage.”

Patsalides described the current monetary-policy stance as “neutral to restrictive” and said interest rates were at an appropriate level based on the information presently available.

“I would say neutral to restrictive. Overall, I think we are at the right level. Let us see,” he said.

Asked whether the current environment called for restrictiveness, Patsalides replied: “No. Interest rates are where they are supposed to be, given the latest situation, information and assessment. Tomorrow may be a different day.”

But he underscored anew the way in which the passage of time was changing the balance of inflation risks.

“But, again, as time passes, given the energy crisis and the natural propagation process, the risk of inflation is higher every day,” he said.

Patsalides also rejected a return to directional forward guidance under current conditions, saying that signaling a likely policy path could cost the ECB honesty, flexibility and credibility.

He said policymakers might have personal views or feelings about where rates were heading, but those should not be communicated to markets when uncertainty was high and decisions would ultimately have to be based on evidence.

On the ECB’s minimum reserve requirement, Patsalides said the issue should be considered as part of the forthcoming review of the operating framework rather than as a separate monetary-policy decision.

“My own view is that this should be discussed within the operating framework review. It is not related to monetary policy per se or to the interest rates per se,” he said.

“As for the level of reserves, I have an open mind, but I prefer not to think about it before I am presented with the analysis and all the factors that will play into it.”

The teams responsible for the operating framework were expected to begin work in the autumn, Patsalides said. He added that the current environment of volatility and uncertainty would not be an ideal time to announce a change, although he hoped conditions would have calmed by the time the review was completed.