Ex-ECB Vice Constâncio expects a quick decline

Frankfurt Vítor Constâncio is an optimist with regard to inflation in the euro area. “Energy and food prices have already fallen sharply, and they account for around two-thirds of inflation here,” explains the Portuguese, who was Vice President of the European Central Bank (ECB) from 2010 to 2018. “Europe is benefiting from these price falls far more than the USA, where energy and food cause just under a third of inflation,” he emphasized in an interview with the Handelsblatt. His conclusion, therefore: “I expect a rapid fall in inflation here.”

In December, the inflation rate in the euro area was 9.2 percent, after a high of 10.6 percent in October. Core inflation, which excludes energy and food prices, edged up to 5.2 percent in December. If you also take out indirect energy costs in various sectors, the result is a value of around four percent, which, according to Constâncio, better represents the “broad, homemade price increase”. This Wednesday, the European statistical office, Eurostat, will publish a first estimate of inflation in the euro zone in January.

The economist expects inflation to be around three percent at the end of the current year. For 2024, he considers the ECB’s forecast to be far too high: The central bank expects a value of 3.4 percent, partly because of the expiry of state aid to dampen energy prices.

Constâncio, on the other hand, considers the result of 2.3 percent of an expert survey by the news service Bloomberg to be “more realistic”. This puts him in line with Olivier Blanchard. The former chief economist at the International Monetary Fund (IMF) expects that inflation will no longer be a major issue in the coming year.

Nevertheless, Constâncio sees two risks for the price development. On the one hand, the opening of China after the tough Covid lockdown could cause energy demand and thus prices to rise again. However, he believes that this effect would be offset by the significantly weaker economic development in the USA, Europe and the emerging countries. In addition, China is a long way from growth rates of up to eight percent in recent decades.

On the other hand, excessively high wage increases would be a risk – but Constâncio sees no signs of this at the moment: “In the euro area, up to and including September, they only increased by just under three percent, i.e. far less than prices.”

Constâncio advocates foresighted action

In view of the interest rate decision by the ECB this Thursday and beyond, the former deputy chief hopes that the central bank will act with foresight. Otherwise, he fears, there could be unnecessarily large rate hikes. “With the prospect of a recession and a prolonged war in Ukraine, unnecessary risks should be avoided.” Italy’s ECB Director Fabio Panetta recently made a similar statement.

Constâncio explains: “Monetary policy must always be forward-looking for two reasons. Once, because it only works with a delay. And secondly, because it only wants to reach its inflation target of two percent in the medium term.” The central bank sees price stability at this value.

In his opinion, with a deposit rate of 3.0 or 3.25 percent, the ECB should “first wait and see whether prices develop in line with consensus estimates”. Because this interest rate is currently 2.0 percent, there is still some leeway.

ECB in Frankfurt am Main

The central bank will decide on its further course on Thursday.

(Photo: dpa)

Some economists see the high national debt as an important factor currently driving inflation. They argue that the resulting additional demand leads to higher prices when supply is relatively rigid.

Constâncio does not share these fears. It refers to budget deficit estimates by the EU Commission. According to this, around 3.7 percent of the gross domestic product (GDP) can be expected in the euro area for 2023 and then 3.3 percent for 2024. For the primary deficit, which excludes interest costs, she expects it to fall to 1.3 percent by 2024. “With such deficits, demand is not fueled in such a way that it contributes to inflation.”

However, he warns against overly optimistic assessments of economic development. “I think we’re going to see at least a technical recession in 2023, that is, a two-quarter decline, even though the outcome for the full year has become more uncertain.”

The economy in the euro area grew surprisingly slightly in the fourth quarter of last year, at 0.1 percent, as Eurostat announced on Tuesday. In the previous quarter, however, the economy had increased by 0.3 percent.

In the US, where there is more detailed data than in Europe, the According to the Portuguese, a technical recession is already in sight. Constâncio points to the inversion of the yield curve: the yield on three-month US Treasuries is more than one percentage point higher than on ten-year bonds. Such an inversion expresses the expectation of a future decline in interest rates triggered by a recession. In the case of a shrinking economy, it is more likely that the central bank will support the economy again. Constâncio points out that the current interest rate differential is particularly large. “This is extreme on a historical scale and has always ended in recession.”

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He also sees another harbinger of economic weakness. “In the USA, house sales have fallen to a lower level than in the recession of 2008 and 2009.” In the euro area, he sees the problem that in some countries in the south, but also in Finland, for example, indexed building rates are common, whose development is directly linked to the key interest rate. “The financing costs have become extremely expensive for them since June, and the demand for living space is falling,” says Constâncio. In addition, employment in the construction sector in the euro area fell for nine months in a row.

Constâncio also urges caution when it comes to reducing the balance sheet

The former ECB deputy is cautious about the planned reduction in the central bank’s balance sheet total, which had already been built up during his term of office through massive bond purchases. Since 2015, the ECB has bought government bonds from euro area countries on a large scale, which has kept the balance sheet from growing. The central bank has announced that it will reduce its bond portfolio by 15 billion euros per month from March by no longer completely replacing maturing paper with new purchases.

For the period from July, a new decision should then be made about the pace. But Constâncio does not believe that this dismantling should be accelerated later. He calls it “an inevitable normalization of monetary policy, but one that needs to be done carefully.”

15 billion euros corresponds to around 50 percent of the expiring bonds. “That’s not a small amount,” he emphasizes. In addition, the balance sheet total is also falling due to the repayment of the low-interest loans, known by the abbreviation TLTRO, to the commercial banks. His conclusion: “For the current year, the balance sheet can be expected to shrink by around 1.5 trillion euros, which is more than that of the Fed in the USA.”

From Constâncio’s point of view, it is clear that the balance sheet should no longer shrink to the level before it was built: “For the time being, I could imagine a value of around three trillion euros for the ECB in order to maintain the current way of implementing monetary policy, which has been in place since October 2008 applies.”

Traditionally, central banks have kept liquidity tight and lent money to commercial banks at short notice if necessary – the key interest rate was controlled via this mechanism. Since 2008, they have started pumping plenty of liquidity into the market, which the commercial banks then reinvest with them. In this way, the central bank can set a lower limit for the money market interest rate through the interest rate that it pays to banks. This new procedure is “much simpler and safer” than the previous one, says Constâncio, because the banks’ liquidity needs do not have to be estimated.

Program for heavily indebted countries is under criticism

With the extensive halt to bond purchases, another topic has come up again: the question of how the ECB can support heavily indebted euro countries like Italy. The ECB has therefore launched a new program, known as TPI, which allows it to make targeted bond purchases under certain conditions if the yields in an individual country – and thus the costs of financing – rise sharply. This is partly criticized because it mixes monetary policy even more with fiscal policy.

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But Constâncio says: “It’s a good program. Ideally, its availability ensures that it never needs to be deployed, similar to the older OMT program that continues to exist, giving multiple safeguards. It helps when the markets know it’s ready.”

He doesn’t think TPI is any more politicizing of the ECB than the older OMT program, which has far tougher conditions attached to central bank intervention. In both cases, he argues, the EU Commission will primarily judge whether a country is complying with fiscal rules. This is an important first assessment.

And in both cases, TPI and OMT, the ECB ultimately has to decide whether to intervene. He makes it clear: “Ultimately, it’s always about avoiding a pure liquidity crisis under the pressure of the markets if the country complies with European budgetary rules and thus has sustainable debt.”

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