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“The ECB should cut interest rates — not doing so would be a mistake”, A Conversation with Vítor Constâncio

This interview is available in French and Spanish on the Grand Continent website.

A monetary policy decision where an October rate cut takes place on Thursday is now in full swing in light of new data on inflation and economic activity. Inflation in September came in at 1.8%. The ECB aims for inflation below, but close to 2%. What do you expect the ECB will do and why?

A single point of inflation below 2% does not guarantee that the target was attained in a consistent and stable manner. Still, it is a powerful indication that the drivers of disinflation continue to operate. Therefore, I expect a further interest rate cut of 25 basis points, particularly in view of the prolonged stagnation of the economy that will continue to push down the pricing power of firms and their wage decisions. With all that in mind, that would be my assumption for this week’s meeting.

If the ECB doesn’t cut interest rates on Thursday, will that be a policy mistake?

The data warrants a rate cut in October.

So yes, it would be a policy mistake that I think they won’t commit.

What do you anticipate will move the needle for the ECB in terms of the pacing and the magnitude of cuts going forward?

Philip Lane, the chief economist of the ECB, suggested in the minutes of the last monetary policy decision that inflation could accelerate in the last months of the year. If those expectations were confirmed, I wouldn’t be as categorical about a further cut in December

Having said that, the Governing Council has not been as forward-looking as it should be in my view. Monetary policy responds to medium-term goals and takes time to produce effects. Personally, I anticipate that inflation is on a downward trend and will stabilize around 2%. That would justify another cut in December in interest rates of 25 basis points.

Do you believe the ECB, as some would argue, was late in the hiking process and now risks also being behind the curve on the easing path especially if the economic picture continues to deteriorate?

There were hiking delays of just a few months that were not as crucial as many like to think because the inflation spike, driven by external price shocks, was unavoidable in the short term. In these types of episodes, the role of monetary policy is to increase rates to keep stable the expectations of future inflation and prevent the risk of significant domestic second round effects that can amplify the external shocks. These objectives were accomplished by the ECB and the Fed. This was enough to protect the process of lower inflation driven by international price reductions and achieve an economic soft landing, contrary to what many well-known economists, some of them very influential, argued at the time. They said it would take a recession to “break the labour market” with higher unemployment to tame inflation. And they were wrong. Regarding the new rate cuts cycle, I don’t think there were significant delays.

The ECB’s Governing Council takes decisions often by consensus but not always unanimously, especially in situations of big policy changes. Is that problematic in your view?

I don’t think it has to be. The ECB sometimes makes decisions unanimously; other times, it cannot reach unanimity. What is important is that decisions are taken at the appropriate time.

That is also the argument that is made in Brussels on the executive side. Consensus can be beneficial but it can also slow down the process even if a large majority is in favor and wants to move forward.

I would agree. However, consensus does not mean unanimity, and it would be the attempt to always have unanimity that would be detrimental to timely decisions.

How does the German economic recession weigh on the broader picture?

Germany is the biggest economy in the euro area and what happens in the biggest economy is very relevant for the rest. In that sense, a German recession significantly affects growth in other euro area countries and that is a powerful negative contribution to the current economic stagnation that we are seeing.

The ECB has repeated it is data dependent, not Fed dependent. But moves from the Federal Reserve condition the global debate on monetary policy. How do you expect the language and communication from the ECB to adapt vis à vis the US?

The US is the largest economy in the world, and the dollar remains the dominant international currency. So, the world’s monetary and financial cycle is determined by the actions of the Fed. In terms of policy, the recent inflationary spike was determined by international events, mostly the war in Ukraine, and the process developed similarly in all advanced economies, so that has contributed to some behavioral similarities. Every central bank in the world has to take into account the Fed’s decisions, but it doesn’t mean every central bank has to do exactly the same. The ECB cut interest rates before the Fed, and that worked fine. Financial markets understood that the ECB has its own path, sometimes different from the Fed.

The ECB looks at data overall but has had a keen interest in particular points like service inflation and wage growth. What is the difference between being data dependent and being data point dependent?

I don’t like the expression “data dependent” because it can lead to the interpretation that past or real-time data determines policy decisions in a way that is backward looking. It would be better if central banks would simply say: “We are not pre-committing to future decisions”.

I also find the distinction between “data dependent” and “data point dependent” a little unnecessary. Particularly because it says little about the appropriate degree of forward-looking behavior in decision-making, which is crucial for the good conduct of monetary policy. The attention to particular sectoral prices, like for services, as you mention, is justified if it is part of a broader assessment of future inflation.

At what point, does the balance change in which individual data points can tilt decision making exponentially?

For monetary policy decisions, data points should only matter as far as they impact the prospects of future inflation, and that has to be assessed on a case by case basis.

How low do you believe can go in this cycle when it comes to cutting rates in this new environment?

My baseline scenario about economic and inflation developments, with all its uncertainties, is that the euro area economy will continue to be weak and that inflation will reliably stabilize around 2% by mid next year. In this scenario, I would forecast for the ECB a policy rate between 2.5% and 2.75% in that time frame.

That is for monetary policy, but what about fiscal policy, what role can it play?

This is an important question. History proves that monetary policy is asymmetric in its efforts and not very efficient in taking an economy out of recession. Europe has deep structural challenges and needs a big jump in public investment to address them. It also needs to crowd in private investments. Unfortunately, the European fiscal rules and the debt break legislation in Germany do not allow for those kinds of policies. Meanwhile, France and Italy have been accumulating high deficits and high debt for a while and that will require a gradual reduction. That means we can only expect a continuation of weak growth in the euro area even if monetary policy rates go below 2.5%. The housing sector is the only sector that has a meaningful response to interest rates, contrary to general business investment, which can’t be stimulated by cutting interest rates alone. The European recovery needs fiscal policy, but it doesn’t seem to be available. And that is a problem because I don’t see how Europe can respond to these challenges, security, digitalization, and climate change by applying the current fiscal framework. New investment initiatives funded at the European level are essential.

Mario Draghi, who you know very well as he served as President of the Governing Council of the EBC while you were Vice-President, said in his report that it is “unquestionable” that a European safe asset would help to boost liquidity, lower the cost of capital and enhance the role of the euro. Do you agree?

I do agree and I have been saying this for years. A deep and liquid bond market in a European safe asset is a crucial part of Capital Markets Union (CMU) that would facilitate the financing of the private investment that the European Union needs. It is a big waste that we achieved the more difficult currency union but cannot take the necessary decisions to reap the benefits of a true CMU. More packages like the NextGenerationEU would help, but more than that is needed for a complete CMU.

Lastly, we have talked about the uncertainties facing Europe and there many: the internal politics, sustained economic stagnation, the volatility around the US election etc. What is your biggest worry?

A Trump win. I think he is a menace to Europe.