Interview with Olli Rehn, Governor of the Bank of Finland and Member of the Governing Council of the ECB
"Independence does not mean isolation"
Mr. Rehn, if we put 2020 under the headline "The pandemic and the great economic crisis" - what headline do you expect for 2021, or what are you hoping for?
Hmm... "Continuing to build bridges over troubled waters, but seeing the light as the year progresses"? But that might be a little long for a headline....
"Overcoming the pandemic and economic recovery" would be too optimistic for you?
A lot depends on whether we succeed in getting the virus under control. The ECB forecast assumes vaccinations to be well ongoing in the first half of 2021. Recovery is expected to start in 2021 and gain further ground in 2022 . "Containing the crisis and starting the recovery" - that would probably be a better short version of my headline.
So you are entering the new year with a certain degree of optimism?
It is crucial that the vaccines are effective and that they can be distributed quickly. In Europe, vaccination is expected to be well ongoing in the first half of 2021, so that the wide population would be vaccinated by the end of the year. This assumption is also included in the ECB baseline scenario.
And then the economy can take off as well?
The economic recovery is starting somewhat later than initially thought because of the second wave of Covid infections - but it is coming. The recovery is postponed, but not cancelled. The economy will increasingly get back on its feet in 2021 and make up further ground in 2022.
Are you worried that there will be another recession in the winter half-year? There are signs of a decline in economic output in the fourth quarter due to Lockdown 2.0. So is a double-dip recession looming?
We expect near-zero growth in the first quarter of 2021. A double-dip recession can thus hopefully be avoided. But there is no doubt: We are facing another very difficult phase in the short term. The winter and spring will be very tough and involve serious risks to public health and economies . But thereafter, the outlook is brightened noticeably by the prospect of vaccines.
In the short term, however, the crisis has intensified again, not least in Germany. How worried are you, especially with regard to the largest euro economy?
I view the situation in Germany with the same great concern as that in Finland and elsewhere. Of course, there are certain differences in the incidence of Covid-19 infections from country to country. But we are all in the same boat in Europe. There is a second wave and new restrictions everywhere. The second wave will have to take its toll on the economy in the short run . But with rigorous short-term restrictions on social life and sensible behaviour by people, we can contain the pandemic and thus also limit the damage to the economy.
But if the crisis lasts longer and the recovery comes later, the risk of permanent damage will also increase?
There is always a risk that a crisis will leave longer-term scars. The longer the economic crisis lasts now, the greater the risk of such scarring effects. For example, unemployment may rise structurally or productivity in the economy may fall permanently. There is also the risk that banks' losses from lending will increase. That's why we need to get over the second wave as quickly as possible. But that's the positive news: we can see the light at the end of the tunnel. That is why it is so important that we continue to build bridges for the economy in the still difficult times ahead.
So with monetary and fiscal policy?
Monetary and fiscal policy are currently working in tandem - unlike in many previous crises. For the ECB Governing Council, one thing is clear and central: We must do everything necessary to maintain favourable financing conditions - for households, for companies, but also for governments. In this way, we ensure that the crisis does not worsen, and we create the conditions for the economy to recover later on. But even more important is that fiscal policy supports the economy. That's why the EU's Recovery Fund - "Next Generation EU" - is so important and why the recent agreement among states is so essential. Over the next three years, these funds can drive the necessary modernization of the economies. It is crucial that we do not lose sight of the longer-term challenges.
What exactly do you mean by that?
We must do everything we can now to overcome the pandemic and the economic crisis. At the same time, however, we must think about the tasks of the post-crisis period. Low productivity, for example, has been a problem for a long time and it remains a challenge. The same goes for the transition to a digital and sustainable economy. And it also applies to sustainability of public finances.
What does that mean in concrete terms?
In Finland, for example, we have a significant structural sustainability gap in our public finances. This year and next, we need a substantial fiscal stimulus to support the economy, i.e. households and companies. But all measures must be targeted and temporary. This very expansionary fiscal policy must end when the crisis is over. Then we need to go back to closing the sustainability gap.
So you're not one of those economists who believe that public debt has become completely unproblematic in view of record low interest rates?
I am not yet a convert to Modern Monetary Theory.
Adherents of this theory argue that countries with their own currency need not worry about their debt because they can be financed virtually indefinitely by their central bank. Less radical economists at least argue that interest rates will remain permanently low and that public debt is therefore of little concern.
Interest rates will rise again one day. That's what we need to keep in mind when building bridges. Healthy public finances continue to be a high priority.
Is fiscal policy in Europe doing enough in the crisis? The volume of the Corona Recovery Fund of 750 billion euros dates back to the summer, when the situation was much better. And other regions are currently already on the second or third stimulus package.
You have to look at the euro zone and at Europe as a whole. Most of the short-term fiscal support comes from the member states. Germany, for example, is doing a lot to provide fiscal support to the German economy, and that is a very important part of the European response to the crisis. The EU recovery fund is a very important supplementary element. The funds will support the economy starting next year and then increasingly into 2023.
So you don't share the view that Europe is lagging behind the USA or Japan?
I don't see it that way at all! The support is of the same order of magnitude in largest economies. Incidentally, I see the recovery fund almost in a Schumpeterian sense: However, it is not about "creative destruction" but about "creative rejuvenation" of the economy in the euro zone and in Europe. In the recovery phase, public investment will be key. That is precisely what the fund is aimed at.
Would you be in favour of making the recovery fund, including the possibility for the EU Commission to borrow heavily, a permanent institution?
When the EU heads of state and government agreed on the fund, they clearly stated that they wanted to set up a fund with a considerable volume, but that it should be temporary. However, it is also clear that in the long term we need an instrument at EU or euro level that can be used for macroeconomic stabilization. As EU Commissioner, I proposed a euro fiscal capacity which would be crucial for the lasting well-being of the monetary union.
You have praised the "tandem" of monetary and fiscal policy. Where do you see the limits to this cooperation or even coordination? Aren't you worried about the independence of the ECB?
Coordination is an essential element of policymaking because it is the policy mix that matters. Coordination also does not per se imply an attack on the independence of the ECB. Tommaso Padoa-Schioppa, one of the founding fathers of the euro and a former ECB Executive Board member, once said: independence does not mean isolation. Those are very wise words. There is a clear division of labour. Fiscal policy has its responsibilities - strong growth, high employment, sustainability, etc. And we in the ECB Governing Council have the mandate of price stability. As long as our mandate is not compromised by this, we are very happy to support other objectives with our monetary policy, such as sustainable growth and the highest possible employment.
In Germany, many critics smell monetary financing, especially with the Corona emergency bond purchase program PEPP, which is in fact deliberately aimed at supporting individual crisis countries like Italy in an emergency.
I am very familiar with these discussions and the concerns about fiscal dominance of monetary policy. But the current crisis is a very good example of how effective a coordinated countercyclical fiscal and monetary policy can be. At the same time, there is a clear institutional division of labour in the EU Treaty. My colleagues and I are very strict about our independence in the Governing Council!
You don't see the risk of fiscal dominance, in other words, that fiscal policy will gain the upper hand and monetary policy can no longer pursue the goal of price stability? Bundesbank President Jens Weidmann says that the massive increase in government debt makes this risk much more acute.
I understand the concerns about fiscal dominance, and I agree that we need to be very vigilant. But don't worry: as the Governing Council, we will make sure that we can ensure price stability at all times and not be overrun by fiscal policy. What worries me more are the high debt levels per se. They are a drag on growth and productivity. That's why it's so important that the funds from the recovery fund is used wisely. The result must not simply be higher debt. The result must be more growth.
Many Anglo-Saxon economists think the discussion is overblown anyway. They argue that in stress times central banks – including the ECB –must also act as lenders of last resort to governments.
The role as lender of last resort in Bagehot's sense refers more to warding off market panic and panic in the banking system. It has nothing to do with guaranteeing very low financing costs for governments in the long run. One, interest rates will go up. Not today, not tomorrow, but at some point for sure. Governments need to be aware of this and prepared for the fact that the current environment of zero interest rates will not last forever.
For now, however, it will. In mid-December, the Governing Council even approved another package of measures, including increasing the Pandemic Emergency Purchase Program (PEPP) by €500 billion to €1.85 trillion. Euro and extending it until at least March 2022. At the same time, the statement that the 500 billion euros need not be used in full has raised eyebrows. So is that a kind of ceiling?
The central aim of all our measures is to secure the favourable financing conditions for some time to come. If we succeed in maintaining these favourable financing conditions without exhausting the PEPP volume entirely, it will not have to be used in full. In this respect, the 500 billion euros are currently a kind of ceiling. At the same time, however, we have communicated quite clearly that the volume could be increased again. This could become necessary if the pandemic lasts longer than expected and this exerts further downward pressure on inflation. This is not the likeliest scenario. But we also need to keep a very close eye on possible less favourable scenarios.
Given the ECB's baseline scenario, which sees inflation at only 1.4% in 2023, well below the medium-term target of below but close to 2% - is it right to assume that further topping up is more likely than not fully exhausting it?
We need to fulfill our mandate and meet our inflation target. The pandemic has now taken us off the previous path toward that goal. So we are maintaining a very high degree of monetary accommodation. And President Christine Lagarde has made it clear: We remain ready to use all our instruments if necessary to achieve our inflation target in a sustainable way. This also applies after the December package.
In mid-December, President Christine Lagarde said that favourable financing conditions were the ECB's compass. By contrast, former ECB President Jean-Claude Trichet has always stressed that the only needle in the ECB's compass is price stability. Does that mean that the inflation target is less important in the current environment?
The compass is favourable financing conditions and the needle in the compass is price stability. So the favourable financing conditions are a means to fulfill the mandate of price stability.
In addition to the PEPP expansion, the Governing Council has also increased the attractiveness of and announced more cash injections for banks, the TLTROs. In contrast, it did not touch the key interest rates and left the deposit rate at - 0.5%. Does this mean that further rate cuts are not really on the table, despite forward guidance to the contrary? Critics argue that further rate cuts could be rather counterproductive because the so-called reversal rate has been reached.
TLTROs have been very effective in ensuring that banks lend enough to the real economy. That's why they continue to be one of our main tools. As for the reversal rate: it is hard to say exactly where this rate is. In any case, it is lower than generally thought before the global financial crisis. But our forward guidance is crystal clear: We see the key interest rates at the current level or lower for the foreseeable future. This clearly demonstrates that, in our view, the reversal rate has not yet been reached. As I said, we are ready to use and adjust all our instruments if necessary - and that also applies to key interest rates. There should be no doubt about that.
And an interest rate cut will be used if the euro appreciates further?
I am sure you are well aware that the ECB does not have an exchange rate target. It is also important to bear in mind that the recent appreciation has been strongly driven by factors on the dollar side. But that does not mean that the appreciation is not important. For example, it leads to a loss of competitiveness. The exchange rate affects the growth and inflation outlook and is thus an important parameter in achieving the inflation target. We monitor exchange rate developments very closely and we will continue to do so in the future.
The second big issue for the ECB at the moment is the review of the monetary policy strategy. Does it amount to a change in the inflation target in the direction of a point target of 2% with an explicitly symmetrical interpretation, i.e. that undershooting is combated in the same way as overshooting?
I cannot speak for the Governing Council. We are also in the middle of the debate. You'll have to be patient there. But as Governing Council members, we should stimulate the debate. In that respect, I'm happy to tell you about some of my views.
In the current environment of low inflation, negative demand shocks and low interest rates, the key question for monetary policy is how to ensure that inflation and inflation expectations do not drift permanently below the medium-term inflation target. There are two ways to reduce the risk of inflation being too low and to raise inflation expectations: First, by having a clear and truly symmetric definition of price stability and, second, by having a reaction function that underscores the commitment to symmetry and that takes into account the increased probability that monetary policy will reach the effective lower bound on interest rates. The debate on the merits of so-called "make-up" strategies also belongs in this context.
That means the approach of compensating for inflation rates that were too low in the past by rates above the target in the future. This approach is also being pursued by the U.S. Federal Reserve with its new "average inflation targeting". Is this a model for the ECB?
The Fed's new approach is the result of extensive analytical work in the central bank and in academia. Of course, as ECB, we have to make our own decisions, based on conditions in the euro area. But of course, we benefit a lot from the intellectual debate in the US. As the ECB Governing Council, we also don't operate in a vacuum - neither in terms of monetary policy, nor in terms of the strategy review. And there are some important parallels between the U.S. and the euro area. This is particularly true for the flattening of the Phillips curve. This strategy of average inflation targeting strategy has benefits, and it makes perfect sense for us to take a close look at that.
Another much-discussed question is what role the ECB should play in the fight against climate change. In particular, how do you view a "green" monetary policy, for example, explicitly favouring green bonds in bond purchase programs?
It's very tempting to ask central banks to do more and more. That's true on climate change and many other issues. But these demands often involve quite complicated trade-offs. It's also about the independence of the ECB and our ability to ultimately deliver price stability - which is our main objective. Indeed, the fight against climate change is primarily a task for national governments and democratic institutions. From an economist's point of view, the best solution would be a global carbon tax or a global price on CO2.
But that means you would be cautious about an explicitly "green" monetary policy?
That's a discussion we need to have. We have to look at how climate-related issues can be included in the ECB strategy and thus also potentially in the implementation of the refinancing operations and the asset purchase programs. As long as green objectives do not jeopardize our price stability mandate, we should do our part of the job. But the primary responsibility really rests on the shoulders of national governments in Europe and around the world. It is also important to remember that the ECB already holds a significant amount of green bonds, about 20% of the eligible universe. We also do not want to disrupt markets or create green bubbles – as we don’t want to create bubbles of any other colour.
Finally, a sentence on the debate about a digital euro: Does Europe, do Europeans need the digital euro?
A digital euro offers a number of advantages, even if cash use in Europe is not declining as fast as elsewhere. It's important that we kicked off the discussion this year and that the ECB and the Eurosystem joined in. We have made a big leap in the debate and preparation this year - from being a laggard to spearheading it. We will continue to look at this and hopefully start an experimental phase next year. I think it is likely that we will have a digital euro in the next five or ten years. But one thing is clear: It's not about replacing cash, but complementing it.
The interview was conducted by Mark Schrörs.
Olli Rehn is Governor of the Bank of Finland and a Member of the Governing Council of the ECB.