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"It is better to prepare for the worst"

Interview with Olli Rehn, Governor of the Bank of Finland and Member of the Governing Council of the European Central Bank (ECB)

Mr. Rehn, when you look at the euro area and the euro area economy, how worried are you about the economic slowdown and the many risks? Is there any reason to be alarmed?

The big problem is that the uncertainty in the global economy has persisted for a rather long time already - mainly triggered by the global trade conflicts. This is also reflected in Europe and the euro area. Growth in the euro area has slowed significantly recently. At the same time we are not forecasting a recession. However, we should no longer see the recent slowdown in growth as a brief temporary dip in the economy, as a "soft patch". We are experiencing a longer phase of weaker growth. This calls for an ample degree of monetary policy stimulus.

US President Donald Trump and China's President Xi Jinping have now agreed on a kind of truce in the trade dispute. The USA and China are now again working on a solution to the conflict. But you remain cautious?

The agreed trade truce is good news. But we must wait and see how that develops, and if it lasts. A possible escalation of the trade war remains the biggest risk for the euro area economy. This is evident not least in Germany and Finland. Both economies are very export-oriented. If the world economy and world trade weaken, both countries feel this immediately. The recent weakness of the German industry is also mostly a consequence of the trade conflicts and thus a cause for concern for the euro area as a whole.

Do you still expect a noticeable recovery of the euro area economy at the end of this year or next year - or have you given up this hope?

That depends on whether the politicians can remove the existing risks. Trade conflicts are the number one challenge. The second big challenge is the slowdown in the Chinese economy. China is already taking fiscal countermeasures and this can limit the slowdown. Third, there are geopolitical risks such as the Iran conflict. All of this fuels uncertainty and this uncertainty dampens investment and growth. Politicians should now finally solve these problems in a good and peaceful way. As central bankers, however, we should prepare ourselves in case there is a stronger and prolonged slowdown in growth. My philosophy is always that it is better to prepare for the worst than to simply hope for the best.

Would you say that the outlook for growth and inflation has deteriorated or improved since the Governing Council meeting in early June?

The current situation is broadly similar to that at the beginning of June. Since then, the data has painted an almost unchanged picture. The feared negative developments around the globe have not yet materialized. At the end of the month, we will see how the economic and political challenges have developed worldwide. As you know, we meet every six weeks. We have the opportunity to review our position in July and September.

In other words, the Governing Council's meeting on 25 July will first be concerned with an assessment of the situation - and there is no time yet for decisions on further easing?

I do not wish to anticipate our deliberations. I respect and appreciate the collegiality of the Governing Council. However, ECB President Mario Draghi was very clear recently: We are always ready and determined to act if necessary and to adapt or use all our instruments. We are monitoring and analyzing the situation very closely.

After the last interest rate meeting, it was said that if the situation deteriorated, the Governing Council would act. In Sintra, Draghi said that without an improvement in the outlook for growth and inflation, additional stimulus would be needed. Does the ECB need new bad news to act, or is it already enough that good news is missing?

Whatever words you choose, I think one thing is important: We are ready to take further action if we think it is necessary to achieve our price stability target in the medium term and in a sustainable manner. That is our yardstick.

However, the Governing Council's confidence in achieving the inflation target of below but close to 2% in the medium term has declined significantly?

The current ECB economists' projections for headline and underlying inflation are some way from our definition of price stability. Now we see a positive trend in wage growth. However, this has not yet been reflected in an increase in underlying price pressures as we expected. What is also of great concern to us now are inflation expectations. Market-based inflation expectations have fallen sharply and remain far too low.

They are close and sometimes at all-time lows.

Many people then ask: Why is this a problem? But there are two sides to it: On the one hand, low inflation is good for economic stability and savings. On the other hand, too low inflation affects the effectiveness of monetary policy because it more frequently hits / bumps on the effective lower bound of interest rates. It also hampers economic adjustment between countries in the euro area. If we really want to live up to our mandate, further monetary stimulus is now needed until there is improvement in economic and inflation prospects.

Would you say that inflation expectations have already "de-anchored”, so moving away from the ECB's 2% target?

The question of anchoring inflation expectations is essential but in some way also a very  philosophical one. Let us keep it simple: Market-based Inflation expectations remain too low, and that is a cause for concern.

So is the ECB's target of below but close to 2% no longer credible?

I think we cannot deny that there are doubts among market participants and the public about the ability of the central bank to achieve the price stability target. That is why it is particularly important now that we are very clear both in our policy-making and in our communication. We must underline our determination and ability to take monetary policy measures that help to achieve our price stability objective. We have a number of instruments which are very effective and which, as a package, have even greater effects than isolated.

That is more concrete?

We have the opportunity to further strengthen our forward guidance. We can opt for lower and/or low policy interest rates for longer. We can resume the net asset purchases. We have already started the third round of our targeted long-term refinancing operations, the so-called TLTROs. This clearly shows that we have the necessary toolbox to achieve our price stability target.

Are interest rate cuts the first line of defense, while the hurdle to restart Quantitative Easing (QE) is higher?

We have parallel defense lines. Some are deeper than others. We will analyze what the best options are and we will end up doing this very collegially in the Governing Council. At the next meetings we will take the necessary decisions to achieve our medium-term price stability objective.

Banks in the euro area are warning against further lowering the deposit rate from the current -0.4% into negative territory, as this would continue to weigh on institutions' profitability and lending. The German financial supervisory authority Bafin has even warned that further interest rate cuts may force some banks to close.

We have clearly indicated that we will consider measures to mitigate the possible negative side effects of negative interest rates in the event that we continue to cut interest rates or hold on to very low rates for much longer. We are currently analyzing this very carefully.

Is it also an option to lower the main refinancing rate from currently 0% and thus bring it below zero, or is it just the deposit rate that is at stake when interest rates are lowered?

We have the entire toolbox at our disposal. However, when we are currently considering lower interest rates, this usually refers to the interest rate on the deposit facility.

Was it a mistake that the Governing Council stopped the QE net asset purchases at the end of 2018?

At the end of 2018, the economic outlook had not yet deteriorated to such an extent that we felt we needed additional stimulus from further net asset purchases. However, I would like to stress one thing very clearly at this point: We have not finished QE! We have only decided to keep the amount of the asset purchase program constant at around 2.6 trillion euro. We continue to reinvest the money from maturing securities in full. But we can also resume buying new assets at any time.

In the case of government bonds, however, the ECB would quickly reach self-imposed limits, at least for some countries, such as buying a maximum of 33% of a country's government bonds. Are these limits up for grabs? They played a central role in the QE proceedings before the European Court of Justice (ECJ) and the Federal Constitutional Court. At the end of July, Karlsruhe will again deal with the complaints against QE in an oral hearing.

I took another very close look at this. The ECJ and the Federal Constitutional Court have clearly underlined the independence and flexibility of the ECB within its mandate. At the same time, they stressed that all measures must be proportionate and necessary. We should not exclude individual instruments a priori until we have carefully analyzed their advantages and disadvantages. We need to look carefully at what they can currently do for the economy and what possible negative side effects there are, including legal issues. We should analyze the whole range of instruments before crossing some of them out.

So, as ECB President Draghi hinted, there is flexibility when it comes to the QE limits?

There is a certain degree of flexibility. As a central banker and member of the Governing Council, I would not want to restrict our room for manoeuvre a priori and prematurely. I endorse what ECB President Draghi has said. That is in line with the ECJ's assessment.

Is it also an option to buy other classes of assets - such as bank bonds or shares or ETFs, as the Bank of Japan is doing?

I always think it makes sense to think outside the box. That doesn't mean that it always leads to different decisions. But it often helps to think creatively and not to limit yourself too much. We have to be creative and we have proven that we are. The OMT program in 2012 is the best example of this. It's about doing what is best economically - the first-best solution, as economists call it. It's not about second-best solutions just because they seem more politically feasible.

If, as expected, the Fed were to lower its key interest rate in the near future and possibly already in July, this would increase the pressure on the ECB to do more, also in order not to risk a significant appreciation of the euro, wouldn't it?

We have no exchange rate target. What we are doing is geared solely to our mandate of price stability. We are guided by economic developments in the euro area. The same applies to the Fed and the USA. It is important that this remains the case. A currency war would only make the situation worse now.

But an appreciation of the euro would make it more difficult for the ECB to achieve its 2% target.

Once again, the exchange rate is not a target for us. But of course it is perfectly clear that the exchange rate has an indirect effect on price stability. We will be monitoring this very closely.

You have repeatedly advocated a review of the ECB's strategy and cited the US Federal Reserve as a model. The Fed has just explicitly put its monetary policy framework to the test. What exactly do you have in mind?

It would certainly make sense and be beneficial to review the ECB’s monetary policy framework. The last time this happened was in 2003. Over the past 16 years, however, the economic environment and the political instruments have changed considerably.

And what exactly are you thinking of? Can you imagine a change in the 2% target, is it about more flexibility or do you have the instruments in mind?

What I have in mind is a combination of two things: Firstly, a systematic research program is needed to clarify the analytical puzzles of these days. For example, there is the question of the lower equilibrium interest rate, the flatter Phillips curve and the low inflation expectations. On the other hand, there should be a broad dialogue with the public. This should involve companies, trade unions, other stakeholders, but also citizens. The aim would be an in-depth analysis of the current challenges in order to increase a common understanding of how the economy has changed, how monetary policy works and which instruments are effective. It is about being better prepared for the challenges of the future, such as globalization, technological change and the ageing of societies.

So you have no concrete result in mind? In the US, for example, it seems that the Fed could change its strategy in such a way that it has to make-up for past mistakes in the inflation target in the future - in the sense of an average inflation targeting.

No, I have no concrete result in mind. We should certainly maintain price stability as our key objective. But we could discuss our definition of price stability. Strategies such as those the Fed is now debating are certainly worth discussing. In any case, we should end up with a common understanding of the effectiveness of the various monetary policy instruments, to make sure monetary policy stays effective in the medium-to-long-term.

What exactly do you mean by a discussion of the definition? Is it a question of increasing or reducing the target of below but close to 2%, or of clarifying the always invoked symmetry of the target?

That is a fair question. Without resorting to excessive exegetics, my answer would be: clarification. Applying a sensible symmetric approach, inflation may vary around 2% in the short-term, to reach our target in the medium term. President Mario Draghi in Sintra said very clearly that "our medium-term orientation implies that inflation can deviate from our aim in both directions, so long as the path of inflation converges back towards that focal point over the medium-term policy horizon." Looking ahead, we stand ready to adjust all of our instruments, as appropriate, so that inflation continues to converge towards our inflation aim in a sustained manner, in the medium term.

Some of your colleagues in the Governing Council argue that now is not the time because the short-term economic challenges are so great. A policy debate should be held when the target is achieved and not when it is missed.

Of course, the timing is an issue. The Governing Council of the ECB is currently very busy with the short and medium-term challenges - and rightly so. But people can also ride bicycles and chew gum at the same time. It is therefore possible to focus on the short-term and at the same time organize a process to achieve better decision-making processes and decisions in the medium and long-term. We are in the middle of a long process of economic transformation, triggered by technology and digitization. We need to understand this much better.

One current example of this change is the digital currency Libra, which is being planned by Facebook and others. What do you think of Libra? Does the project entail risks for financial stability?

This is still a project in the making. We are observing this very closely. This is high on the agenda of supervisors and central bankers and rightly so. We have now discussed it in the Governing Council of the ECB and also within the BIS. There is a broad consensus that we must be prepared to regulate Libra and that we need a globally consistent approach. That is why there is now also a working group at the G7 level. This should prepare the ground for regulation.

Will Libra increase the pressure on central banks such as the ECB to issue their own digital currency, possibly accessible to everyone and not just to banks? In Germany there is now also a political demand for an electronic euro - similar to the planned E-Krona in Sweden.

We have also looked at various options at the Bank of Finland, although it is clear that a solution would always be needed for the euro area as a whole. As central banks, we should be part of this debate and get involved. But we should not jump to conclusions. There are a number of disadvantages and obstacles with digital central bank money for everyone, such as the possible effects on the banking system. It is easier for small countries like Sweden to experiment than it is for a large currency area like the euro area. Caution is called for here.

Finally, a completely different question: The EU heads of state and government have nominated Christine Lagarde, head of the International Monetary Fund (IMF), to succeed ECB President Draghi, whose term of office ends at the end of October. It would be the first time that the head of the ECB does not come from the circle of the ECB’s Governing Council and is not a central banker and economist. Can this be a problem, especially in view of the current difficult situation and the great challenges in the future?

I don’t see it that way. I have warmly congratulated Christine Lagarde and wished her best of success as the next ECB President. In the crisis we worked together in the Eurozone fire brigade, and I am sure her broad and deep policy experience and proven leadership in the IMF will be big assets for the Eurosystem. I am sure we all support her and will do teamwork, which is much needed, for the sake of Europe.
The interview was conducted by Mark Schrörs.

4th of July 2019

Olli Rehn is Governor of the Bank of Finland & a member of the Governing Council of the ECB.