This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
Inflation has come back and so, inevitably, has tighter monetary policy. The European Central Bank, the second most important central bank in the world, has a particularly difficult task in managing this period of monetary tightening. This is not just because the “low for long” period, in which the challenge had been to raise inflation towards the 2 per cent annual target, came to an abrupt end in 2021. It is also because the eurozone has been disrupted by huge real shocks, notably Russia’s invasion of Ukraine.
Philip Lane, the ECB’s chief economist, is in an extremely influential position at this vital juncture for the eurozone’s still young central bank. The position is made more significant by the fact that the president, Christine Lagarde, is herself not a professional economist.
Lane has a doctorate in economics from Harvard, is an internationally respected macroeconomist and was governor of the Central Bank of Ireland from 2015 to 2019. Since he joined the ECB board in 2019, he has had to help the institution cope with huge challenges. They are not over.
Our discussion began, naturally, with the inflation shock.
Martin Wolf: From your perspective, how much do you see the big rise in inflation as having been due to a supply shock or a demand shock, globally and also within the eurozone?
Philip Lane: The way to think about the last two years is that this supply versus demand question has to be addressed at a sectoral level.
We clearly have a supply shock in energy; and the pandemic had previously led to a supply shock in contact-intensive services. But there have also been two sectoral demand shocks: one was for goods, because there was a big switch towards consumption of goods; and then the post-Covid reopening took the form of a demand shock for services, notably in Europe.
You have to take account of this sectoral differentiation. In Europe, we do not have a big rise in overall demand. But we have had this global mismatch in goods, which led to bottlenecks, and then, over the past year, a reopening effect on demand for services.
So, this is why we at the ECB say there are both demand and supply channels at work. But it’s best not to view these at the aggregate level.
MW: Isn’t it also true that the impact on prices of strong demand elsewhere — in the US, for example — will look like a supply shock to you?
PL: There’s a large global component to inflation.
Let me slightly amplify the point. On one level, the big increase in global prices of commodities and goods clearly reflect global demand and supply. But, since Europe is a big producer of manufactured goods, that has also boosted export prices for European firms.
So, it’s not just that the prices of imported goods have increased. Europe has also been a beneficiary of high demand for its exports. We see that in cars and in luxury goods. And so, even though Europe has suffered a lot from high import prices for energy over the past year, there’s been a partial offset via higher export prices.
MW: There are two views on what has happened.
One is we’ve had a series of unexpected shocks to the world economy: the pandemic; then the swift opening, which brought unbalanced demand; and then the energy shock. So, the world went crazy and we’ve simply done our best to manage it.
The other view is that monetary policy fuelled the flames, with a long history of ultra-loose monetary policy, followed by a gigantic monetary expansion in the early period of the pandemic. And this was then made worse by huge fiscal expansions, notably in the US. So, the central banks and fiscal authorities bear the blame for this.
How would you respond to these different views?
PL: I’m going to be firmly in the first camp of essentially saying that we have had these very large shocks.
For me the way to differentiate these narratives is that before the pandemic we had five years of low interest rates, but little inflationary pressure. So, the idea that the world we lived in was creating an inflationary environment just doesn’t ring true.
We did have very large quantitative easing and very low interest rates, and this did limit the disinflationary pressure, keeping inflation in the eurozone at around 1-1.5 per cent rather than allowing outright deflation. But we were not creating inflationary pressure. So, I don’t see that today’s inflation came out of excessively loose monetary policy.
What is true, however, is that once these shocks had occurred it became important to move away from the super-loose monetary policy. If we had kept rates super low for too long, they might have translated into self-sustaining inflation. That’s why we have moved away from low interest rates and quantitative easing over the last number of months, when this inflation shock turned out to be fairly large and quite durable.
MW: Again, there are two sides.
One says that most of this inflation is going to fade away, partly because the base effect of the high prices of a year before is going to lower annual inflation a great deal. Also, inflation expectations look well anchored and the labour market well behaved, at least in Europe. So, the real danger is that you are going to persist with tightening or “normalisation” for too long. Given the long and variable lags in monetary policy, you’re going to create an unnecessarily deep and costly recession.
So, that’s one side. But the other side, someone might say, is that many households are suffering a big negative shock to real incomes, which they are only [now] beginning to realise. So, there is a lot more labour market pressure to come and you are going to have to tighten a great deal and then stay there for a long time.
In other words, there are the risks of doing too much and too little, in a situation of extreme uncertainty. Which risk do you currently think is the bigger and on which side do you think the ECB should err?
PL: These risks need to be taken seriously. But these have different prominence at different phases of the monetary policy cycle.
The first phase for us was indeed to normalise monetary policy, to bring interest rates away from the lower bound towards something corresponding to neutral rates. We have done this. So, now we have the policy rate at around 2 per cent, which is in the “ballpark” of neutral.
Yet we are still not where the risks become more two-sided or symmetric. So, we need to raise rates more. Once we’ve made further progress, the risks will be more two-sided, where we will have to balance the risks of doing too much versus doing too little. This is not just an issue about the next meeting or the next couple of meetings, it’s going to be an issue for the next year or two.
It’s important to remember that we meet every six weeks. We will have to make sure we take a data-dependent, meeting-by-meeting approach, to make sure we adjust to the evolution of the two risks.
What does that mean? We have to keep an open mind on the appropriate level of interest rates. The big error would be maintaining a misdiagnosis for too long. The risk is not what happens in one meeting or in two meetings. What happened in the 1970s was a misdiagnosis over a long period of time. The issue here is flexibility in both directions, to make sure that policy is adjusted in a timely manner, rather than maintaining a fixed view of the world for too long.
MW: Are you reasonably comfortable, in retrospect, with the decisions you’ve made over the last couple of years? Do you feel that not only are you in a reasonable place, but that you’ve made sensible judgments?
PL: Fundamentally, yes.
Let me, first, give you a reminder of the last 15 months or so. Inflation pressures were starting to build from the summer of 2021. So maybe the first meeting at which this was sufficiently visible in the data would have been December 2021. But December 2021 was also when the Omicron variant was emerging.
We did make an adjustment in December 2021 by firming up the ending of the PEPP [pandemic emergency purchase programme] from March 2022. Then, at the February 2022 meeting, we signalled a faster pace of reduction in asset purchases. We got out of a very large programme of quantitative easing by June 2022. And then we started hiking in July.
So, what we did between December 2021 and June 2022 was focus on reducing QE, before starting to raise rates, in the knowledge that we could move relatively quickly once we started raising rates. The debate about the exact timing is misplaced, because we knew that we could always catch up if it turned out that rates needed to be moved more quickly. In the end, where we are now is reasonable.
Any debate about whether we moved too slowly on rates has to be assessed in the context of being willing to move at a fair pace once we started hiking. This debate should not be about when exactly a central bank starts raising rates. After all, the yield curve jumps in anticipation of what we are expected to do and we’ve also proven an ability to move quickly.
If you asked your readers a year ago what probability they would put on the ECB’s being at a 2 per cent policy rate by the end of 2022, I don’t think many would have bet on that. So, we’ve proven we are responsive and we’ve also proven our determination to deliver our inflation target. 2022 was a year of a big pivot, a big transition from accommodative towards restrictive policy.
By the way, we do have a symmetric target. It was always important to demonstrate the symmetry. In the same way that we were active in fighting below-target inflation, we also have to be active in fighting above-target inflation.
MW: How would you articulate the condition of the eurozone economy in comparison with the situation in the US?
PL: US inflation is clearly more of a textbook case, in that a lot of inflation is coming from the demand side. The labour market has been hot, with a lot of vacancies, limited labour supply and so on. And it’s clear that monetary policy is working to cool down the labour market in a classic way.
We have a more complicated situation in the euro area, because a lot of the inflation is connected to a negative terms of trade shock. We have declining real incomes and falling real wages, and a big supply component to the inflation.
Regardless of where the inflation comes from, one has a risk of “second-round” effects, in which high inflation gives rise to upward pressure on wages and profit mark-ups. Monetary policy has to ensure that the second-round effect doesn’t become excessive or persistent.
The fact that we have a negative real income shock in Europe, which the US does not have, because it’s an energy exporter as well as an importer, means that the scale of monetary policy tightening needed to adjust inflation to target is smaller in the euro area than in the US. We both have a 2 per cent inflation target. But delivering 2 per cent means that interest rates will differ substantially between us and the US.
MW: One of the consequences of this divergence has been a fairly big rise in the dollar. Does this shift in the external value of the currency cause issues for your policymaking?
PL: It’s on the list of factors we look at but it’s definitely not at the top of the list. The euro area is a continental-sized economy. But there is a spillover from global monetary policy, because the rate of growth in the global economy and the rate of price increases of global commodities and other tradable goods are globally determined.
We also have to take into account the downward pressure on inflation from tightening by other central banks around the world, which generates weaker demand for our exports and lower import prices. But this is not particularly via the euro-dollar rate, but rather via the global dynamics for commodities and tradable goods.
MW: There’s a debate over whether the inflation, the rise in interest rates, the tightening of monetary policy and the move away from ultra-loose monetary policy represents a temporary blip, a big blip, but still a blip. Alternatively, is this the point at which we are moving into a more “normal environment” with nominal interest rates well away from zero and real interest rates positive rather than negative?
Do you have views on this?
PL: Let me strongly differentiate the nominal versus the real sides of this story.
For me, there are three regimes: one, inflation chronically below target; two, inflation more or less on target; and, three, inflation above target.
Before the pandemic we, in the eurozone, had had inflation at around 1 per cent for too many years. So markets believed that interest rates would be super-low indefinitely. And that can be self-sustaining because expectations would rationally be that inflation remains below targeted in that scenario.
But I don’t think we’re going back to that. The inflation shock has proven that inflation is not deterministically bound to be too low. The narrative I often heard before the pandemic on the “Japanification” of the European economy has gone quiet.
I think this will be a lasting result. So, if expectations have now re-anchored at our 2 per cent target, compared to being well below it, interest rates will go to the level consistent with that target, not back to the super-low rates we needed to fight below-target inflation. For nominal rates, that makes a big difference.
On the second question you posed, which was on the equilibrium real interest rate, I would be in the agnostic camp. It’s not clear whether there will be a large movement in the equilibrium real rate.
Let me point to a couple of indirect mechanisms here. One is that in the pre-pandemic period some of the anti-inflationary forces were coming from globalisation. There were also the anti-inflationary effects of the deleveraging and fiscal austerity after the global financial crisis and European sovereign debt crisis.
It’s a fair assumption that globalisation is going to be different. At the very least, there will be more concern about the resilience of supply chains and so forth and also more concern for security. This means that inflation is going to be more sensitive to domestic slack and less to global conditions. How big an effect that will have is uncertain. But it is a structural change in the world economy.
The other point is that we had deleveraging after the global financial crisis and the European sovereign-debt crisis. In a number of countries, households had to reduce their household debt. Also, we had a number of years when governments felt they had to run austere fiscal policies, or were forced to do so. This, too, was bad for aggregate demand.
In the pandemic, however, governments had to run big deficits. That spending was transferred to households and firms. Also, the pandemic created “forced savings”, because there was less opportunity to spend. So, household balance sheets look better now than before the pandemic.
So one factor that will be different now is the globalisation process. A second factor is where we are in terms of the balance sheets of the private sector and the governments. Governments will have to pull back from the high level of fiscal support they offered during the pandemic. But by and large it should be a normalisation of fiscal policy rather than a sudden stop in fiscal support. The fact that households have better balance sheets now also means that support for aggregate demand after the pandemic will probably be stronger than before the pandemic.
MW: So this inflation shock has got rid of this environment of self-reinforcing low inflation and this is, to some degree, a relatively benign outcome.
PL: You can classify it as a byproduct of this shock. It has reminded the world that inflationary shocks can happen. And we absolutely see that in our surveys. If we go back to a year and a half ago, most of the distributions of inflation expectations were below 2 per cent. As you know, expectations have a strong effect on medium-term inflation and, as a consequence, on steady-state interest rates. So, yes, absolutely, I don’t think the chronic low-inflation equilibrium we had before the pandemic will return.
MW: So, we might have inflation at target, monetary policy credible at delivering the inflation target, and a continuation of low real interest rates. In an economy with a lot of debt, this sounds like an ideal combination.
PL: Well, it is important to recognise that it still requires work. We’re not yet at the level of interest rates needed to bring inflation back to 2 per cent in a timely manner. Governments also do need to pull back from the high deficits that remain. So, a significant fiscal adjustment will be needed in coming years. But, that adjustment should be a return to some normal situation, as opposed to a forced overcorrection.
In the first years of the euro, big imbalances were built up. Then there was a painful correction from 2008 until about 2015 or 2016. I don’t think that this high volatility will be repeated on this occasion. It’s more a question of returning from this unusual pandemic situation to a more normal state of affairs. We haven’t seen “normal” in Europe for a long time.
MW: Where do you think interest rates might end up before this is over?
PL: Here I’m going to repeat the point about data dependence. We’re working under very high uncertainty. Let’s just take one concrete example: compared to where we were in mid-December, when we had our last meeting, there have been big declines in energy prices. A lot of that has to do with mild weather in recent weeks. So, this is a simple example of why we must not be so confident about where interest rates need to go.
It’s still the case now in mid-January that we run many scenarios about where interest rates are going to need to go. Under the vast majority of them, interest rates do have to be higher than they are now. As we discussed earlier, risks are not yet two-sided, and under a wide range of scenarios, it’s still safe to bring interest rates above where they are now. And this was the communication at our last meeting.
Where exactly we end up will depend on a lot of factors.
Let me go back to one thing you said earlier on, mechanical base effects mean that we do have inflation coming down a lot this year. So, for Q4 2023, our projection of inflation back in December 2022 was that we would be at around 3.6 per cent. Compared to being at 9 per cent at the end of 2022, that’s a fairly big decline. But it is mostly base effects. And then, in terms of interest rates, the question is how do you get from mid-threes at the end of 2023 to the 2 per cent target in a timely manner?
That’s where interest rate policy is going to be important. It’s to make sure that the last kilometre of returning to target is delivered in a timely manner. So, what I would also say is that, because we haven’t had so many tightening cycles in recent memory, another source for uncertainty is that the sensitivity of inflation to interest rates varies a lot across the different models we run.
And this is why we would say, and the Fed would also say, that one of the big issues for this year is to observe the impact of the tightening we’ve already done. Last year we could say that it’s clear that we need to bring rates up to more normal levels, and now we say, well, actually we need to bring them into restrictive territory. But in terms of deciding where eventually the level is going to be, there will be a feedback loop from experience.
What we would expect to see in the coming months is the impact of the interest rate hikes that happened last year for investment and consumption. In turn, that will help us decide how powerfully the interest rate hikes are affecting the real economy and the inflation dynamic.
Anyone who says they know for sure what the right level of interest rates will be must, apart from everything else, have a lot of confidence in their model of how the world works. The prudent approach is, instead, to observe the feedback from the tightening last year.
The policy rate only moved in the summer but the yield curve has been moving for a year. We are seeing the effects of this in the behaviour of banks, the bond market and the financial system. The interesting phase now is the response of firms, households and governments to the change in financial conditions.
MW: Let me move on to “market fragmentation”, or divergences in monetary conditions across member states. How significant a risk do you think this is? And do you have the tools needed to manage it?
PL: So, let me give you a two-level answer to that.
The first level is that the biggest risk of fragmentation occurs when you have economic conditions that are misaligned across the EU area. And this is what we had prior to 2008. Because we had large differences in growth rates, current account deficits and credit conditions, in that first decade of the euro, many indicators showed a lot of divergence.
And when the crunch came, the countries that needed to make a correction were going to have a number of years of difficult economic circumstances — low growth rates and shrinking economies. Those are the conditions in which risk of financial fragmentation would be most intense.
A lot of measures were taken to reduce those fundamental differences. We have not seen large current account deficits in recent years, we have not seen large differences in fiscal deficits and we have not seen large differences in credit conditions. So, we do not have the ingredients for big divergence now, though this can always recur in the future, because there could be bad luck or bad policy choices.
And let me add that during the pandemic, Europe also launched NextGenerationEU. So, there’s now jointly funded debt directed at the economies which suffered most in the pandemic. This is now going to be a big platform for reform and public investment in countries like Italy, Spain, Greece and so on.
That’s one level. The second level is that over the past year there has been a significant change in the nominal and inflationary environment. That might have caught some investors by surprise. In the process of normalisation, there’s always the risk that there could be market accidents, there could be non-fundamental volatility.
That is why we thought it important to introduce this extra instrument — the transmission protection instrument [TPI] — last summer. And that fills out our toolkit. Because we now have an ex-ante programme. We have told the world that if we see non-fundamental volatility emerging, we will be prepared to intervene, subject to a set of “good governance” criteria, which means that affected member countries are aligned with the European frameworks.
In sum, in terms of fundamental forces of volatility or divergence, Europe looks to be in reasonably good shape and in terms of non-fundamental volatility, which is a more elevated risk in a time of transition, we have expanded our toolkit, by having the TPI.
MW: There are people who note that we are experiencing a considerable change in the monetary environment for the financial sector. So, there is discussion about potential risks of financial instability. How do you perceive that in the ECB?
PL: Since the start of unconventional monetary policy it was clear that there was a potential risk. What happens if there’s a sudden change in the interest rate environment? So, in principle that is a risk factor.
It has been greatly mitigated in the European context not just by banks, but also by individuals. So, there has been a lot of “macroprudential” regulation, in terms of limits on loan-to-value ratios, limits on debt-to-income ratios and so on. The ability to exploit super-low interest rates via excessive leverage might exist in some pockets, but it was not pervasive.
The evidence is that we’re not seeing this very high vulnerability to the big change in interest rates. In the less regulated non-bank sectors of the financial system, losses may have accumulated. But we have a bank-based financial system and the banks are heavily supervised and regulated.
For banks, rising interest rates help via some channels, such as net interest income. To the extent that the European economy is hurt by the slowdown, they face some risks in their loan books. But again, we think the European economy will be growing again in 2023. Our current assessment is that if there is a recession, it’s going to be mild and short lived.
So, I’ll be cautiously optimistic that we’re able to make this transition away from “low for long” towards a more normal situation.
But again, let me go back to the running theme of this conversation, which is high uncertainty. If it turns out that inflation is much stickier than expected, that there’s more of a downturn in the world economy, that higher interest rates have to be higher than is currently expected by the market, we will be keeping a perpetual eye on financial fragility.
MW: One other question about credibility. Let’s assume you’re correct that inflation will go back to target. Nonetheless, there will have been quite a jump in the price level. So, people will have suffered permanent losses on nominal assets. They might then say “well, this has shown us that big jumps in the price level can happen”.
People may say to themselves “well, maybe they’re going to do this to us again and so maybe we should be cautious about owning these sorts of assets”. And a big part of monetary stability is designed to make people feel confident that these assets are reliable in terms of their real value.
PL: There’s two parts to that analysis. One is whether, after this period of high inflation, the 2 per cent inflation target will be seen as credible by people in general. I think monetary policy can deliver that, by making sure inflation comes back to 2 per cent in a timely manner.
But then, there is the second part, which is the implications for nominal assets and what assets people may wish to hold and what one means by the safety of “safe assets” after this inflation surprise?
When you think about it, for me, it’s going to be more of a forward-looking question. First of all, I’m not going to disagree with you. Before the pandemic we had a negative inflation-risk premium. Interest rates were low not just because inflation was below target, but the risk distribution was seen as skewed to the downside. We would now expect to see an inflation risk premium being more substantial. People rationally update their beliefs about the world.
It’s 40 years since we’ve seen this happen. And then the question is: how would that risk premium be priced? Is it going to be seen as a once in 40-year kind of risk factor? And with that kind of frequency, it’s not going to have that much effect. But, as you know, these kinds of rare events are priced by the market, to some extent. And we may see more of an inflationary risk premium, maybe more demand for index-linked products and so on.
And that’s an open question.
MW: Can you comment briefly on fiscal policy and its relationship to monetary policy — an issue Mario Draghi talked about quite a bit — as well as the fiscal policy framework, which is being discussed again by eurozone governments.
PL: This is a multilevel debate. In the end, everything has to be anchored on sustainable debt levels. If debt levels are, in the medium term, anchored at a moderate level, governments can respond aggressively to large shocks, such as the pandemic or the energy shock.
So, any fiscal framework should be embedded in a clear debt anchor. Politically, it’s not easy to deliver a strategy that will reduce debt ratios over time. But it is essential.
Let me add that a lot of the fiscal support in Europe consists of price subsidies, which are different from broad-based increases in government spending or broad-based reductions in taxes. So, the direct impact of fiscal policy is to lower inflation right now. But in our projections, it is expected to raise inflation in 2024 and 2025 when these subsidies are scheduled to be removed.
So, when you look at what’s happening now, there are two different conversations. One is how fiscal policy is currently lowering inflation through subsidies, followed by the reversal of those subsidies later on. The other is the broader issue about the appropriate level of fiscal support in the economy.
And what I said earlier on is true. We need to get to a normal situation where fiscal policy is not excessively loose, because it’s hard to say you need expansionary fiscal policy when we have low unemployment. But we also don’t want to get to an excessively austere fiscal policy which would be an excessive drag on the economy.
So, as I said earlier, we have not had “normal” in Europe for a long time. We really should be setting up a system to deliver a normal, stable, macroeconomic environment, including a normal, stable fiscal policy.
MW: Just on your first point, there are member countries, some of them important, which do have high debt levels both by historical standards and by most norms. You are implying that these should be lowered. Given relatively modest low structural growth rates, that’s quite a challenge, isn’t it?
PL: Right, so we have to be forward looking about this. We have to have a situation where, there is consensus that debt ratios have to come down. And we do need a fiscal framework that supports governments in delivering a steady and sustained decline in debt ratios. It’s not going to be easy. But again, in order to have the room to be aggressive when you need to be, you need to return to safe fiscal positions when the opportunities arise.
MW: What do you think of the arguments that have been put forward, by Olivier Blanchard, for example, that the 2 per cent target is too low. It pushes you to the zero-bound too easily. And so we should really have a slightly higher inflation target?
PL: There’s a lot of value in the stability of the inflation target. So, for me, at this point, maintaining an exclusive focus on 2 per cent as the inflation target is the best strategy.
MW: What is your view of the usefulness of a digital euro?
PL: So, what I would say is that where we are now is abnormal. We have essentially a big move away from state-provided money towards a much lower use of currency, of state-provided money, in favour of private sector alternatives.
The anchor of the monetary system and the anchor of an electronic or digital monetary system should be a state-supplied digital currency. So, I’m very much in favour of having a digital currency. But, in the same way that currency is a relatively minor fraction of overall transactions, a digital euro is not intended to become the dominant way we transact. But a digital currency will allow Europe to have a more stable and secure digital economy. So, digital currency is necessary and desirable as an anchor for a generally digitalised economy.
MW: But you do think this can be done without destabilising banks? And particularly bank deposits?
PL: Absolutely. Yes, so it’s fair to say that the interest and the energy the ECB is putting into the digital euro is with conviction that this will not be a threat to the stability of the banking system.
The above transcript has been edited for brevity and clarity
