Interview with Klaas Knot, President of De Nederlandsche Bank und Member of the ECB’s Governing Council

“We as central bankers should act with more modesty”
Mr. Knot, if you look at the current state of the euro area economy - would you say that the glass is half full or half empty?

The glass is definitely half full. The euro area economy is experiencing a broad-based expansion and the recovery is increasingly self-sustaining. What we are currently experiencing is a natural softening of growth compared to the cyclical peak of 2017. External demand is slowing somewhat. But domestic demand is still very strong. This is mainly due to the improving situation in the labor market. More and more people are drawn into the workforce. This increases disposable incomes and supports consumption growth.

So you are not too worried about the recent slowdown?

Last year’s growth rates were not sustainable. The current rates are more in line with potential growth - and still above it. There is no reason to dramatize the situation. Of course there are risks, especially from outside the euro area. But the internal resilience of the euro area economy is sufficient for external shocks not to have devastating consequences.

Probably the biggest global risk is currently the global trade dispute. Could an escalation get the euro area economy off track?

So far, the trade dispute is primarily a dispute between the US and China. It is not clear how an escalation of this conflict would affect the euro area economy. It could also lead to the diversion of trade flows from which, in the end, the euro area might benefit. Escalation into a worldwide trade dispute, nonetheless, would certainly lead to lower growth. The new protectionism and the trend towards de-globalization - including Brexit - are bad news for the global growth potential. Our economies would become less productive and less efficient. The effect on inflation, however, is less clear-cut.

This means?

Trade protectionism constitutes a negative supply shock. Such a shock reduces growth, but leads to higher inflation. But if it would also lead to a broader confidence crisis, that would be a simultaneous negative demand shock. That could dampen inflation. The overal impact on inflation is therefore ambiguous. We will have to monitor that closely.

You have addressed Brexit. How worried are you that there will be no agreement between Britain and the EU?

The risk of no deal has always been there. The closer the deadline gets, the greater the pressure. But I still hope that in the end rationality will prevail. Everyone involved must have a self-interest in avoiding a hard Brexit. Geographically, the UK will remain a part of Europe. And geography remains a key factor in economic relations.

Italy is also causing a political stir at the moment. Rome is planning significantly higher fiscal deficits. How should the EU react?

There are legitimate doubts as to whether the budget plans are compatible with the Italian constitution and the EU rules. But this must be established by the guardians of such rules - in the latter case the EU Commission. As an economist, I would add that the plans contain very few measures that would address some of Italy’s longer-term challenges. Italy must unlock its growth potential and I fail to see how these plans would contribute to that.

Could Italy, with its policies, engulf the euro area as a whole in a crisis like 2011 and 2012?

I do not want to speculate. But I observe that current contagion to other member states is much more limited than at that time. Europe has made progress: safety nets have been put in place, imbalances in many countries have been reduced, and the economy is more resilient. The situation today is very different from 2011 and 2012.

And as long as there is no contagion to other countries, there is no reason for the ECB to act?

At the ECB, we have the job of fulfilling our mandate, and that is to deliver price stability.

Full stop?

Full stop! The ECB is not there to correct or compensate purely national policies. Crucial for us is the euro area inflation outlook, and this seems unaffected thus far.

In terms of inflation, the ECB's Governing Council remains confident that it will reach the target of below, but close to 2% in the medium term?

Our confidence with regard to the inflation outlook is unchanged. As long as the economy is growing above potential, capacity utilization continues to increase. There are already bottlenecks in some labor markets. Wage growth is slowly picking up. Overall inflation has been above our definition of price stability for several months. The only thing we have not seen so far are convincing signs of an uptick in core inflation. However, high and rising capacity utilization on goods and labor markets should provide for increasing price pressures in the near future.

In September, core inflation excluding energy and food even fell slightly from 1.0% to 0.9%. A disappointment?

That was a bit disappointing. But if you look at the ECB projections, you see that the coming quarters of 2018 and 2019 are crucial for the expected rise in the core rate. So far, there is no reason to fundamentally question this outlook.

And therefore also no reason to change the course? The net asset purchases (Quantitative Easing, QE) are expected to expire at the end of 2018, but the key interest rates will remain unchanged until well into 2019.

Our monetary policy is on a path of cautious normalization, as I would call it. The euro area economy no longer needs the same amount of monetary policy support deemed necessary a few years ago. That is why we are now winding down our asset purchase program. We anticipate net purchases to expire at year-end. From that moment on, we should focus more on our policy rates again. We should then offer a little more clarity about what we have in mind. In general, the direction of travel is clear, but the pace is flexible and will be data-dependent.

Isn’t there a danger that the ECB will act too late?

Cautious normalization is a delicate but appropriate balance between two risks: on the one hand, there is a risk of falling behind the curve. The peak of the cycle is behind us and inflation has been above our medium-term objective of below, but close to 2% for some months. On the other hand, there is still a risk that the passthrough of rising capacity utilization into inflation will be weaker than expected. In the past, we therefore had to revise our inflation projections downward multiple times. We would like to see more dynamism in underlying inflation.

Your colleague Ewald Nowotny calls for a faster normalization and says he is not alone in the ECB’s Governing Council. This is aimed primarily at the outlook that the key interest rates will not be raised "at least through the summer of 2019". How do you see that?

One should not forget: our forward guidance for the key interest rates is an expectation. That means there are other possible outcomes around this central expectation, in both directions. If our baseline scenario is confirmed in the next few months, we might think again about the pace of our normalization and might not have to wait that long. Everything depends on how the economy develops. We are well advised to wait and see what happens to the external risks in the next few months before giving more guidance on interest rates.

How much guidance can and should the ECB actually give?

We will never be able to announce precise dates. The economy does not follow a straight course. If the crisis has taught us one thing, it is that we know less about the functioning of our economies than we thought we did. We as central bankers should therefore also act with more modesty. This also applies to our communication - to the way in which we anticipate to achieve certain goals.

Do you feel comfortable with your actions?

Uncertainty is part of our business. As a central banker one should therefore retain flexibility and not commit or bind oneself excessively.

Your colleagues Benoit Coeure and Peter Praet say that in the future, the ECB will have to give more guidance on how to proceed after a first rate hike. Would you agree with that?

The second rate hike is likely to be as important, if not more important, than the first rate hike. Two interest rate hikes might create the impression of a pattern. But it is too early to speculate. We should use the rest of 2018 to wind down our asset purchase program and to better understand how global risks are evolving. Then we can consider how we are going to develop the forward guidance and how concrete we want to be. There are several options. We could say something about the possible number of interest rate hikes per year. We could do it like the Fed. One question is also whether the negative interest rates are special and if we want to get rid of them as soon as possible. But before I discuss this with you, first I prefer to discuss it with my colleagues in the ECB’s Governing Council.

Would it also be an option to communicate an interest rate path?

We have not discussed this idea yet. I would not exclude anything in general, I am open-minded. But we would have to look more precisely at the pros and cons of several options first.

In the past, the ECB had the maxim never to pre-commit.

That was in the pre-forward-guidance world. But it is also a legitimate question if and for how long we should continue doing so.

For how long can the ECB stick to zero and negative interest rates before it becomes a problem for banks or financial stability?

At least the banks I know best are currently extremely profitable. In principle, however, the longer the very low interest rates continue, the greater the unintended side effects. There is a significant risk of misallocation of resources, "zombification" of companies, and the overvaluation of assets. Productivity growth and the potential growth rate will then be negatively impacted. We should not stick to the very expansionary monetary policy any longer than strictly necessary.

Now, first of all, the decision on the reinvestments is due. Even after the end of the net asset purchases maturing papers are to be reinvested. Is this about a purely technical process or additional monetary stimulus?

The scope for additional monetary stimulus in the phase of the reinvestments is very limited. After all, capital key and market neutrality remain our cornerstones. One question, for sure, is how long we want to pursue these reinvestments. Market expectations are currently between two and three years. At the moment I have no reason to feel uncomfortable with such expectations.

And from 2019 on the recalculated ECB capital key? Italy's share is likely to fall slightly, the German one to rise.

In principle, I would say that the new capital key should then become our new anchor. But we still have to discuss that in detail, also with regard to any challenges that transition from the old to the new key might pose.

Is there a need for more flexibility in reinvestments in the future? It is discussed, for example, that maturing securities no longer have to be invested in the same country or in the same sector.

There is already flexibility. This applies in particular to the question of how quickly reinvestments must be made in order to avoid cliff effects. So far I am not convinced that it needs more flexibility than currently available. But if there is any problem, we will find a suitable solution.

Would it be enough to decide on it at the December meeting - or would it be better to do so in October?

There are various possibilities. We could also communicate initial intentions in October and make final decisions in December.

But the hurdle to extend QE is high, right?

It would take a serious shock, leading to a significant deviation from the baseline scenario. At this moment I do not see anything like this on the horizon.

What role does the person of the ECB President play in the exit and normalization of monetary policy? ECB President Mario Draghi will retire at the end of 2019.

One should not overstate this question. The Governing Council consists of 25 members. Most of our decisions are data driven. The room for manoeuver around the cautious normalization that has now been initiated is also not particularly large - either in one direction or the other. We should not be distracted by such discussions.

You are also seen as a candidate from time to time. Do you feel honored by this?

That is not particularly relevant to me. In any event, nothing will happen before the European elections in May 2019. Everything that will be said and written about it up to this point only generates unnecessary noise. I do not intend to contribute to this myself.

Whoever will be the next ECB president - will instruments such as QE and negative interest rates be normal tools for the ECB in the future?

Basically, and from a legal point of view, these instruments are available. But the hurdle to resort to these non-standard instruments should be quite high. Large asset purchases or negative interest rates should only be used when there is a real risk of deflationary spirals. The recent crisis was certainly non-standard as well. Not every future recession will be as bad as the one after the global financial crisis. We have strengthened the resilience of our economies and the foundation of the monetary union - with the ESM, with the Banking Union. After the global financial crisis, monetary policy had to shoulder most of the burden alone. That should also not be repeated.

Do you think that the ECB will have raised the interest enough before the next downturn, to be able to counteract with the interest rate policy alone?

What is enough? And when will the next recession come? But it is certainly a legitimate concern that we will not have as much monetary ammunition in the next downturn as we would like to have. This is another argument for holding on to the very expansionary monetary policy no longer than absolutely necessary – even if not the main argument. That is the continuous improvement in capacity utilization.

Fiscal policy currently also has little room for maneuver.

It is very disappointing that politicians have not made better use of the favourable times. This applies to structural reforms, but also to debt reduction. Had member states merely saved the windfall gains from our very low interest rates for fiscal consolidation, public finances would have looked much better today. This is a missed opportunity for which we will pay dearly if the next downturn comes earlier than currently anticipated.

The year 2018 is also already seen as a missed opportunity with a view to reforming the monetary union.

The functioning of the monetary union would clearly benefit from more financial integration. In this context I do believe that the issue of public risk-sharing between the euro area member states is somewhat overrated. In succesful federations like the US, private risk-sharing across state borders is about five times as important as public risk-sharing. We should therefore focus on completing the Banking Union and on creating a Capital Markets Union. At the end of the day, it also needs a joint EU deposit insurance.

Back to monetary policy: do you see a need after the global financial crisis to put central bank mandates, strategies and objectives to the test? Especially in the US Federal Reserve there is an intense debate, for example about the 2% inflation target.

I see no reason to change our definition of price stability. There are convincing arguments why we aim for below, but close to 2% in the medium term. An increase or a reduction would come with significant drawbacks, including but not limited to our credibility. I am a bit concerned, however, that we have lost some flexibility when it comes to our interpretation of the medium-term. This concept was deliberately left open in the ECB’s early days. Today, a connection is often made with the end of the ECB projection horizon, roughly two years out. This also suggests a degree of controllability of inflation, which clearly there is not. Staff projections are an important input to gauge the extent to which we fulfil our mandate, but they cannot substitute for our judgement. Sufficient flexibility in the medium-term horizon would also allow us to better take account of financial stability concerns.

Some experts argue for a separate financial stability mandate.

A separate mandate would not be the appropriate way. Our mandate should be limited to price stability. However, we should interpret our price stability mandate to encompass financial stability. After all, financial instability can have a huge impact on price stability. Financial crashes lead to deflationary developments. We cannot and should not ignore the value of preventing those.

In the crises, there was much criticism of the central banks. Do you see the danger that the era of independence could end?

I would be extremely worried if the independence of the ECB and the national central banks were put into question. If the ECB had not been independent, the measures in recent years would certainly have had destabilizing effects on inflation expectations - with potentially grave consequences. Take a look also at the developments in Argentina or Turkey. Those may seem far away and not comparable. But they reveal the consequences of undermining central bank independence. I am counting on European decision-makers to be smart enough not to go that route.

The criticism stems not least from the assessment that the central banks have intensified inequality, because, for example, the rich benefited primarily from QE.

The effects of the very expansionary monetary policy on the income distribution are much more multifaceted than the view on asset prices alone suggests. For example, our monetary policy has also led to a significant drop in unemployment. House prices for the middle class have also gone up. There are always winners and losers from a particular monetary policy. But this is no different with regard to interest rates than with non-standard measures. In general, the best protection for people’s disposable incomes is to maintain price stability - and that is exactly what we do!

The interview was conducted by Mark Schrörs

Börsen-Zeitung, 08.10.2018


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