Klaas Knot, De Nederlandsche Bank

„We must not fall behind the curve under any circumstances“

Klaas Knot, President of De Nederlandsche Bank and Member of the ECB Governing Council, warns urgently against underestimating the risks of inflation in the eurozone – and against the ECB taking countermeasures too late.

„We must not fall behind the curve under any circumstances“

Mr Knot, are you more optimistic or pessimistic about the year 2022?

It is difficult to put it into one word – optimistic or pessimistic. What is clear is that the start of 2022 will also be dominated by the pandemic and by elevated uncertainty. I am concerned about the health situation. But our economies have learned to cope better with each new covid shock. With each new wave the economic damage has been less severe than with the previous one. The Delta variant did not even lead to a recession again.

So the new Omicron variant will also not end the recovery either?

Omicron may slow and delay the economic recovery, but it will not derail it. And for us as the ECB, what Omicron means for inflation is even more important. The likelihood that Omicron will increase inflation is at least as high as the likelihood that the variant will reduce inflation. So our monetary policy response will have to be quite different from the first wave in March 2020.

Even the new developments since the interest rate meeting in mid-December have not changed the ECB’s confidence about the economy? Germany has adopted new restrictions, there is a lockdown in the Netherlands.

Omicron is not yet reflected in the ECB staff projections. But we already discussed possible downside risks to economic activity from Omicron at the meeting. The information since then has confirmed this development. Omicron will dampen growth at least in the first quarter. But in earlier phases of the pandemic, declines in GDP have been quickly offset in the following quarter. People are also continuing to spend money, albeit less on services and more on goods and housing. That should contain its impact on growth.

And what is Omicron doing about inflation now? You mentioned opposing trends. Which will dominate?

Inflation can go either way because of Omicron. Further supply bottlenecks would be inflationary. Temporary declines in aggregate demand would initially put downward pressure on inflation. We have to monitor and remain vigilant. In any case, the situation is fundamentally different than in March 2020, when it was clear that strong demand effects would precede any supply effects. This is what happened, but the intensity of inflation has undoubtedly taken us by surprise.

The US Federal Reserve has now abandoned the idea of calling high inflation “transitory”. The ECB, however, is basically sticking to it. What makes you so confident?

Terms like temporary or transitory are meaningless as long as you don’t give a time frame to them. A market participant recently joked that at the end of the day even the dinosaurs turned out to be transitory – even if they stuck around for a few centuries. But if you look at the composition of inflation now, we are confident that inflation will ease in 2022.


For some factors it is certain that they will fall out of the statistics after twelve months. This applies, for example, to the German VAT or past increases in energy prices. Moreover, another good part of current inflation is driven by bottlenecks in international deliveries, which are also temporary by nature – even if it is unclear how long this will last. Opinions differ, however, as to whether we will end up with an inflation rate below 2%, as the ECB staff projections suggest. It only takes a decline that is a bit less pronounced for us to remain above 2%.

And what do you think?

I am one of those who are not entirely convinced that inflation will fall below 2% again. In that sense, the December meeting was a turning point for me. These were the first projections on the basis of which we could no longer confidently say  that medium-term inflation will indeed fall below 2%. Medium-term inflation projections have not always been very accurate. Especially in times of structural changes, models are of limited use.

Some central bankers argue that the ECB’s job is done. The ECB projections put inflation at 1.8% in 2023 and 2024, and this does not include owner-occupied housing or the minimum wage increases. Is it time to say “mission accomplished”?

I am still holding off on such an absolute statement until I see how inflation plays out in 2022. But even then it is safe to say we are very, very close to “mission accomplished”. The risks to inflation are clearly tilted to the upside, and I believe our forward guidance no longer has to be an obstacle for us to raise rates if we wanted to.

But against this background, are the recent decisions of the ECB Governing Council still appropriate? These stipulate bond purchases for another few years.

We have spent eight years performing a kind of rain dance for more inflation. Now we suddenly have more inflation. But uncertainty remains high. That makes me a little cautious to cry victory. There is too much uncertainty to respond head over heels now. Uncertainty calls for gradualism. That is why I supported the decisions in mid-December. I am comfortable with a scenario where we use 2022 to gradually unwind bond purchases. We will reduce the purchases from €80 billion a month to €20 billion from October 2022. €20 billion creates the option for us to end the net purchases in one step at any time. This would leave our hands completely free in 2023. But if inflation continues to surprise on the upside also into 2022, we can end the bond purchases sooner and move market expectations of the first rate hike further forward.

But you are sticking to the sequence – first end of purchases, then interest rate steps? Austria’s central bank chief Robert Holzmann has questioned this “sequencing”.

I perceive the negative side effects to be larger with prolonged bond purchases. Their impact on housing market access, old-age retirement schemes, and wealth inequality can also undermine social cohesion which I find increasingly worrisome. Such factors should also find their way into our enhanced proportionality assessment, suggestingthey should be ended first.  Additionally, we should not unduly flatten the slope of the yield curve. Maturity transformation is an essential financial service that warrants an appropriate return. So there are good arguments for the current sequencing.

What was also very controversial in the Governing Council was the great flexibility – “whenever threats to monetary policy transmission jeopardise the attainment of price stability”, as it is said in the statement. Is this “whenever” the new “whatever”, so a new edition of ex-ECB President Mario Draghi’s “whatever” promise?

Such analogies are too simplistic.  Flexibility in our asset purchases has served us very well during the pandemic. Flexibility is our most important tool to counter fragmentation. And for me, avoiding fragmentation is a necessary precondition for monetary policy normalisation. Preparing for gradual monetary policy normalisation is appropriate now. But it will not succeed if accompanied by recurrent bouts of turbulence in bond markets.

Critics say that this amounts to a yield curve control or even a kind of solvency guarantee for the states.

That is exaggerated. We have ruled out yield curve control. We are now taking our foot off the “gaspedal” and for me it is crystal clear that the general level of euro area bond yields will gradually rise. That is also desirable in view of the inflation trend. But we must avoid an excessive widening of interest rate spreads that would have a differential impact on different parts of the euro area.

Are the euro countries prepared for such a rise in interest rates? There are major concerns, especially when it comes to Italy.

The governments will have to adapt to the new reality. And as long as borrowing costs rise gradually, governments should also be able to adjust.

Given the great uncertainty, is it really possible and appropriate to rule out a rate hike in 2022?

We have so far ruled out a rate hike based on the current outlook. If new data change something about the outlook, we can react at any time. We meet every six weeks, and every six weeks we can adjust our language, which would have an immediate impact on market expectations for lift-off. My baseline still excludes 2022 but not 2023.

ECB chief banking supervisor Andrea Enria recently said that in the meantime the costs of the ECB negative interest rate for banks would outweigh the benefits. What is your assessment of this?

It is clear that the effectiveness of such instruments diminishes over time as spending becomes less responsive, while the negative side effects increase. It is difficult to say exactly when this will tip over. As I argued before, the corrosive effect of a protracted period of unprecedented monetary accommodation cannot be ignored. I am cautiously optimistic that the inflation outlook will allow us to exit this unprecedented  policy. But this will only be gradual. It’s about evolution, not revolution.

But isn’t there a danger that the ECB, like the Fed or the Bank of England now, will be forced to make a sharp U-turn in the future?

Materialization of upside risks to inflation might require a more rapid turnaround. If we want a gradual and smooth exit, it is therefore even more important that we start early. The last thing you want in such a situation is to fall behind the curve. Once you fall behind the curve, it takes an abrupt, shock-wise correction to get back ahead of it. We must not fall behind the curve under any circumstances.

In Germany, criticism of the ECB is on the rise again. How dangerous is that?

As the ECB, we are there to protect the purchasing power of our citizens. That’s why any inflation that significantly exceeds our 2 percent target is not welcome – no matter where it comes from. But it is also a fact that some 80% of the current high inflation is beyond our control. We don’t have oil or gas fields to push down energy prices. We don’t have ships or containers to reduce freight costs. Our job is to ensure that high inflation does not become entrenched through second-round effects. And we will do what is needed to prevent that. There should not be the slightest doubt about that.

Hence the new reference in the Governing Council’s statement to adjusting the instruments, if necessary. “in either direction”?

We stand ready to adjust our instruments in either direction. And the risks to inflation are clearly on the upside. The combination of these two observations suggest that future policy tightening is more likely than renewed easing.

Will the change at the top of the Bundesbank from Jens Weidmann to Joachim Nagel change the discussion in the Governing Council?

I have always enjoyed working very constructively with Jens Weidmann. I regret his stepping down. But I also know Joachim Nagel a bit and I am very much looking forward to working with him. We all have a common mission, a common mandate – price stability. That binds and unites us.

Would it help the ECB if there were more common fiscal policy at the euro area level? There is, after all, a discussion about making the EU Recovery Fund a permanent instrument.

The most important thing now is to make the EU Recovery Fund a success. For that, the reform part is at least as important as the funding for public investments. If the EU Fund is a success, it will undoubtedly set a precedent for dealing with future crises. But fundamentally, more focus is needed on the countercyclicality of the euro-area wide fiscal policy stance. During normal times this can also be achieved through more binding coordination of national fiscal policies.

Since the beginning of December, you have also been chair of the global Financial Stability Board (FSB). What is your priority there?

There, too, the normalisation of monetary policy will present some key challenges. Lw-for-long interest rates have triggered a search for yield, and where current asset valuations reflect an expected continuation of this benign interest rate environment, they have become vulnerable for a correction once expectations shift. If continued high inflation forced central banks to raise policy rates faster than expected, the implications for financial stability would have to be closely monitored. An abrupt turnaround in interest rates is therefore one of the biggest financial stability risk in the coming years. Another reason why it is so important that monetary policy does not fall behind the curve.

How concerned are you about the record high debt levels around the world after Corona?

High debt burdens lead to structural vulnerabilities that come to the surface when the interest rate outlook changes. Continued vigilance will be called for.

Bundesbank Vice-President Claudia Buch has warned of a new wave of deregulation of the financial system after Corona. Do you share this concern?

The fact that the banking sector helped to mitigate the shock during the Corona crisis and did not exacerbate it as was the case throughout the global financial crisis has a lot to do with the successful regulatory reform agenda formulated after the global financial crisis. The last thing we should be doing now is relaxing prudential standards and weakening the resilience of the banking sector.

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