Pressures on the European Central Bank to raise interest rates are likely to increase unless European governments agree fiscal targets that are ‘more binding, less discretionary and more stringent’. At the same time the ECB will be keeping a close watch on both corporate profits and wage claims to try to achieve ‘sensible’ outcomes.
Nagel stated his understanding for employees in Germany and around the euro area pursuing higher wage claims to offset steep falls in real incomes. But tight labour markets were impeding central banks’ efforts to relieve wage pressure, he said, indicating the ECB would not hesitate from contributing to higher unemployment if this was necessary to bring price rises down to the ECB’s 2% annual target.
Nagel, in formal speeches on 22 and 24 March and a series of associated gatherings, reinforced his focus on preventing near double-digit inflation from becoming embedded in the euro area. He made clear the ECB needed to tighten policy further despite high debt levels and problems at individual banks suffering from the effect of higher interest rates on their asset valuations.
Looking ahead, he said that rates needed to stay at ‘restrictive levels’ for a prolonged period, scotching market hopes that central banks would soon retreat from policy tightening. On the ‘terminal rate’, he said he was ‘not a great supporter’ of model-based calculations of the level likely to end the present rate-tightening cycle, as these were often based on demand-orientated equations that failed to spot the outcome of supply-side shocks. ‘I have my own idea of where the terminal rate is – but I am not going to tell you.’
He adhered to the line that turmoil at some exposed banks – including Credit Suisse – reflected ‘idiosyncratic’ and not systemic difficulties. At the session in Edinburgh, he declined to comment on the steep 24 March Deutsche Bank share price fall. ‘When inflation is stubborn, we have to be even more stubborn.’
Nagel said he welcomed further action to reduce the ECB balance sheet beyond the relatively modest action so far this year. He wishes the ECB to stop repurchasing all bonds maturing under its ‘asset purchase programme’ from July. This would upgrade the present agreement to carry on reinvesting half of the monthly €30bn total of bonds falling due.
He hinted at proposals to stop reinvesting outstanding stocks of bonds purchased under the Covid-19 emergency programme from the end of the year.
Separately the ECB is considering measures to curb losses for central banks and lower profits for commercial banks resulting from sharply higher deposit rates on bank reserves. Raising reserve requirements and lowering interest rates on the liabilities side of European central banks’ balance sheets are believed to be measures under consideration.
Nagel said monetary policy-makers needed to ‘act decisively’ – evidenced by the ECB’s six rate hikes since July as well as the start of quantitative tightening measures to start reducing its excessively high balance sheet. But they also need governments to first decide and then implement euro area fiscal rules. ‘Fiscal policy needs to work with us in the same direction. [Governments] should not use fiscal space for more programmes. Otherwise we will have to do more on the monetary policy side.’
Accommodative monetary and fiscal policy in the past three years has supported economic growth during the period of Covid-19 and Russian-Ukrainian war upsets, helping to avoid the recession many had predicted. The rise in inflation is becoming more broad based, with euro area consumer price index inflation in 2023 likely to be 5.3% (6% in Germany), more than twice the ECB’s 2% target.
Affirming that, ‘We will do what is necessary to return inflation to target,’ Nagel said higher interest rates would cause banks and other market participants to take fewer risks. He indicated that one reason behind the failure of Silicon Valley Bank was a careless attitude towards risk-taking.
Nagel said banking turbulence did not amount to a financial crisis comparable to 2008. ‘We have to do what we can to maintain market stability… We have the right instruments to do this,’ he stated, reinforcing ECB President Christine Lagarde’s reassurance on 18 March. ‘We are coming out of an exceptional decade where money was cheap.’ The outcome of the last financial crisis in 2008 was better regulation and stronger bank capitalisation. ‘There is a lot more we can do from our toolboxes.’
David Marsh is Chairman and Neil Williams is Chief Economist of OMFIF.