Transcript of Governor Philip R. Lane interview with Mark Schrörs, Monetary Policy Correspondent, Börsen-Zeitung

10 Nov 2017 Interview

Mark Schrörs, Monetary Policy Correspondent, Börsen-Zeitung: Mr. Lane, the euro area economy is doing well and growth is even above its current potential growth rate. At the same time, inflation has risen and is around 1.5%. Are the current and the prospective degree of monetary policy accommodation by the European Central Bank (ECB) really still warranted and appropriate?

Governor Philip R. Lane: The economy in the euro area is experiencing a very robust recovery. But unemployment in the euro area as a whole is still high. It should also not be forgotten that the economic recovery is partly based on our very accommodative monetary policy. This includes our forward guidance, i.e. the statements on the future of the bond purchases and of the key interest rates. More importantly, there is still a lack of sufficient signals that inflation is substantially heading towards our target of below, but close to 2%. In the first half of 2018, it might even go back slightly, albeit due to base effects.

The inflation rate of 1.4% recently could fall to 1% or even slightly below - but that would only be temporary because of past fluctuations in the price of oil.

Of course, our goal is for the medium term. Inflation doesn’t have to reach our goal before we discuss changing our policy. But inflation must be clearly on the way towards this goal. At the moment this is not the case. It is therefore still too early for a radical shift in our monetary policy. Over time, as the economic recovery continues, the likelihood that the goal will be achieved increases. Then monetary policy can undoubtedly be adjusted more decisively. 2018 will be an interesting year.

Mark Schrörs: ECB President Mario Draghi expects inflation to converge towards the 2% target by 2020. At the same time, sentiment indicators have reached levels at which the ECB raised policy rates in previous cycles. But now the Governing Council has even extended its bond purchases (Quantitative Easing, QE) until the end of September 2018, albeit from January 2018 with a halved monthly purchase volume of € 30 bn. Are you not worried that the ECB will fall "behind the curve", especially as monetary policy works with a huge time lag?

Governor Lane: First of all, what we have experienced over the past ten years, with the global financial crisis of 2008/2009 and the euro crisis of 2010/2011, is unique. Comparisons with previous cycles are difficult. We have to be very attentive to all the data. There are some signs that inflation is snapping back. I also do not exclude that there could be surprises and that inflation might be higher in the future than we currently expect. But we cannot place big bets on that now. We need reliable evidence that it is going in the right direction.

Mark Schrörs: And in such an environment it is, in case of doubt, better to wait too long with the U-turn than to start the exit too early?

Governor Lane: Our strategy is clear: We will maintain a significant degree of monetary accommodation until inflation is sustainably moving towards our goal. It would not be consistent with this strategy if we now change our policy significantly just because we hope that inflation will pick up. We have to wait and be patient and humble. But if we have enough signals, we can get active and move on. So our monetary policy does not always have to follow such a gradual and incremental approach as it is currently the case. But at a turning point you want to have enough evidence that the time for such a step is really ripe.

Mark Schrörs: Would the Governing Council of the ECB, in view of this uncertainty over the inflation outlook, have also halved bond purchases from January 2018, if there were no problems with self-imposed QE limits such as the 33% issue/issuer limit?

Governor Lane: First of all, we do more, not less! I want to stress that very clearly once. Limits have not played a role in our discussion. We have a positive momentum in the euro area economy, which makes us more confident that we will reach our target of below, but close to 2%. That's why we will reduce our purchases. This decision is consistent with our strategy. The rules of the QE program do not limit us in what we are doing.

Mark Schrörs: If things develop as the Governing Council expects, was the current QE extension the last one?

Governor Lane: We should be completely open-minded. We explicitly did not set an end date and that is very important. When the time comes, we have to make an appropriate decision in 2018, with a view to the data then available. We cannot and should not take that decision now, nine months in advance.

Mark Schrörs: But would you say that the bar for another extension beyond September 2018 is higher than it was the case before?

Governor Lane: It is fair to say that. Hopefully, by September 2018, the economy has continued to grow, the labor market has continued to improve, and the portfolio of assets in our balance sheet has continued to grow - and this is critical to the degree of expansion. As the real economy improves, monetary policy needs to keep pace. As I said, scenarios are also possible where inflation picks up faster than expected. I do not agree with the view that inflation will naturally be stuck at a low level. Take a look at the debate on the Phillips curve ...

Mark Schrörs: ... the connection between unemployment and wages or inflation. Currently, the curve seems to be very flat: The decline in unemployment has not led to stronger wage growth.

Governor Lane: That's true. However, there may be a moment when there is a strong, non-linear response, where wage and inflation dynamics increase very suddenly.

Mark Schrörs: But given such upside risks to inflation, is it not wrong that the Governing Council of the ECB only promises to ease monetary policy even further, if necessary - but not to do less.

Governor Lane: Over the next six to nine months, there are no risks of too high inflation. All in all, there are certainly still downside risks in the short term.

Mark Schrörs: Does the future QE volume of € 30bn per month really warrant a gradual phasing out of purchases, a “tapering” - if it is possible to go in one step from € 60bn to € 30bn?

Governor Lane: We have not decided yet. However, a move from € 30bn to zero is certainly very different from a move from € 80bn or € 60bn move to zero. The nature of any tapering would be very different.

Mark Schrörs: Are market participants too focused on net purchases, also because of the emphasis on purchases in ECB communication, which draws an explicit link with the return to the 2% target?

Governor Lane: I sincerely hope that the markets interpret our communication correctly. Net purchases are an important part of our accommodative monetary policy. But we also made it clear that there is a whole package: There are the high stock of assets in the central banks’ balance sheets, the negative interest rate and the forward guidance. Of course, the relative effect of net purchases was large at the beginning of QE, but it decreases over time.

Mark Schrörs: Will the halving from € 60bn to € 30bn primarily result in lower government bond purchases? The Governing Council has not made that clear.

Governor Lane: At the level of the Governing Council, it is all about the big decision as to what volume the monthly purchases should have. This is a top-down approach. The responsible ECB committees now have to look at what this means for the individual purchase programs.

Mark Schrörs: And then there is a decision at the December meeting?

Governor Lane: The ECB will certainly communicate in due course, how the € 30bn will be divided among the individual purchase programs.

Mark Schrörs: With the ECB’s even longer and strong presence in markets - do you not fear permanent damage to market structures or that governments, companies or banks get excessively used to it?

Governor Lane: It is crucial that everybody - states, corporations and banks - sensibly prepare for rising interest rates and improve resilience. Everything else would be negligent. The current very expansionary monetary policy and the low interest rates are a temporary phenomenon and not a permanent state. On the contrary, our expansionary monetary policy aims at accelerating the economic recovery. When the recovery accelerates, it means that interest rates will rise faster. With our expansionary monetary policy, it will be more likely that interest rates will rise sooner rather than later. It would be a very risky strategy to bet that interest rates will remain so low forever.

Mark Schrörs: However, some observers believe that the ECB will never be able to stop QE completely, because it would immediately lead to renewed doubts about the sustainability of debt in many euro area countries and thus lead to a return of the euro crisis.

Governor Lane: The QE program is aimed at bringing inflation back towards the 2% target. The purchases are not about switching off markets. Our communication is very clear and nobody should doubt that we mean it very seriously.

Mark Schrörs: For how long can the ECB stick to zero and negative interest rates before this becomes a serious problem for banks and overall financial stability?

Governor Lane: First of all let me say one thing: Without our actions since 2014, there would be less growth, less employment, less inflation. There is a high degree of confidence in the Governing Council that our policy is working very well. There is also a considerable degree of agreement that we need to be patient about the return of inflation to our target. This is due to the severity of the crisis we are coming from, and it also has to do with moderate inflation globally. We do not have to reach our inflation target within a year or any other fixed timeframe. It's about the momentum in that direction. As for your question, our policy has so far been positive for the banking sector as a whole. The positive effect on the economy outweighs adverse effects, such as the one on the interest margin.

Mark Schrörs: The key interest rates will remain at the current record lows "well beyond" the end of QE net purchases. What does that mean exactly - at least six months?

Governor Lane: This phrase first of all makes a clear separation: It is one thing to end the net purchases. But it is quite another thing to start with interest rate increases. These two decisions are not mechanically linked. As the day approaches, when net purchases end, we will have to develop a clearer communication strategy, what “well beyond” means. I agree with that and it will happen. That's the big challenge for the next phase.

Mark Schrörs: Many market participants do not expect interest rate hikes until the end of 2019 or even 2020. Are you happy about that?

Governor Lane: These are market expectations. We absolutely have not made a decision yet.

Mark Schrörs: Is it conceivable that in the future the ECB will begin to raise interest rates and reduce its balance sheet at the same time, or will there be a clear order, a “sequencing” - similar to what the Fed did?

Governor Lane: That's a topic for the future. Of course, we are looking very closely at the Fed's experience with its strategy.

Mark Schrörs: Some observers argue that the ECB should accelerate the turnaround also in order to build monetary policy buffers for the next downturn.

Governor Lane: I find this argumentation absolutely unconvincing. Monetary policy has to react to the current environment and make the right decisions. We have a clear mandate and target and that is crucial for us.

Mark Schrörs: Especially in the US, a debate has flared up, whether the 2% inflation target must be reconsidered and raised in the face of a decline in the real equilibrium interest rate - even central bankers participate in it. Do you think 2% is still appropriate?

Governor Lane: It is important that the academic community always critically questions the conventional monetary policy wisdom. For us as monetary policy decision-makers, however, the discussion is currently irrelevant. Our focus is absolutely on our goal and on achieving that goal. It would not be helpful and would only lead to uncertainty if we open this debate now.

Mark Schrörs: But if it there was a review, would there be more good arguments for a higher target than for a lower one, as many in Germany would like to see?

Governor Lane: Once again, we as ECB have a goal and we have to reach that goal. As far as this debate is concerned, there are certainly differences between the euro area and the US. As ECB, we have proved that we are ready to cut interest rates below zero if necessary. 0% is not the lower interest rate bound for us. So our flexibility if inflation is below target is greater than expected.

Mark Schrörs: The Central Banks’ Central Bank BIS and, in particular, its chief economist Claudio Borio, express their doubts that central banks may not know as much about inflation as they always thought, let alone their ability to control it.

Governor Lane: We have to be humble for sure. But I think there are good explanations for the fact that inflation has not returned to its target yet: There is this very deep recession we are recovering from. There are also a number of one-off factors such as the decline in oil prices. However, in my view the underlying inflation mechanism is still intact. There is no fundamental break and inflation is still always and everywhere a monetary phenomenon. Wages continue to be a key driver of inflation and these depend on the labor market situation. It is also crucial that inflation expectations remain anchored. So you should not overestimate the current situation and put everything in doubt.

Mark Schrörs: A completely different topic - Brexit: In the past few weeks, have your worries about a "hard" Brexit with negative consequences increased?

Governor Lane: For the euro area as a whole, Britain is not big enough to be a fundamental factor - neither for the economic outlook nor for monetary policy. In Ireland, this is a little different because we have very strong trade relations with Great Britain. In the short term, however, we can absorb weaker growth in the UK quite well, because there are positive developments: the recovery in the euro area, the upswing in Ireland itself and a no longer restrictive fiscal policy. It would be worse if there were long-term serious trade disputes between Europe and the UK.

Mark Schrörs: Does the euro area need a common fiscal policy, including a finance minister and a budget, to be able to function in the long term?

Governor Lane: We have already achieved a lot: We have strengthened fiscal discipline, we have created the ESM, we have the banking union, even if not yet completed. To what extent a common fiscal policy is necessary for the smooth functioning of monetary union is an open question. Ultimately, this is above all a political decision, a balance between national sovereignty and the sharing of financial resources. In any case, it will certainly lead to a moderate budget. That will not be comparable to the federal financial system in the US.

Mark Schrörs: Will the EU Banking Union never work to its fullest without a Common Deposit Insurance Scheme?

Governor Lane: The nexus between the national banking systems and the respective states will remain in place as long as the deposit insurance is national. Of course, it all depends on the right order and risks must first be reduced. But it is clear that the Banking Union without a Common Deposit Insurance Scheme would always be incomplete. This is an integral part for improving the resilience of the whole system.

Mark Schrörs: You have helped to develop the idea of the so-called European Safe Bonds (ESBies), which are new structured securities build on European government bonds, and you are driving the project forward. In Germany, there is a lot of criticism – it is said that this is an introduction of Eurobonds through the backdoor.

Governor Lane: There are some wrong perceptions. The idea is to combine two things: a diversification so that banks do not overload their books with government bonds from their home countries, and to ensure that banks generally hold safe assets. Banks would only hold the senior tranches of these papers and thus would not risk default. ESBies are absolutely not about Eurobonds. The national states continue to issue the debt. But it would be a mechanism for banks to continue to hold government bonds - but in much safer way than before.

Mark Schrörs: By contrast, the German government is calling for a regime for orderly sovereign defaults in the euro area. Is this a good idea or is there a risk that financial stability will be jeopardized?

Governor Lane: Politicians need to develop a coherent picture of what the euro area financial system should look like and not look at and discuss each issue on its own. In this debate, the special significance of the sovereign bond markets must be considered. We should by no means take this discussion lightly.