Frankfurt/Main ECB President Christine Lagarde has reaffirmed the central bank’s determination to fight record high inflation. “We assume that we will continue to raise interest rates – and withdrawing the stimulus may not be sufficient,” said Lagarde on Friday at the “Frankfurt European Banking Congress”.
The ECB may have to accept that the steps will dampen economic activity: “Ultimately, we will raise interest rates to a level that will bring inflation back to our medium-term target in good time.”
Bundesbank President Joachim Nagel also announced at the congress that the ECB should vigorously continue its rate hike course in the fight against record inflation in the euro area. “In the current situation, the central banks have to prove how determined they are to achieve price stability.” The European Central Bank (ECB) cannot stand still with the interest rate increases so far. Further decisive steps are necessary.
The European Central Bank is aiming for price stability in the euro area in the medium term with an inflation rate of two percent. In the euro area, consumer prices in October were 10.6 percent higher than in the same month last year. In Europe’s largest economy, Germany, the inflation rate rose to 10.4 percent in October.
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“Inflation in the euro area is far too high,” Lagarde said in Frankfurt. In addition, the risk of a recession has increased, although the latest data on growth in gross domestic product have surprised on the upside.
After a long period of hesitation, the ECB has been trying to get the extremely high inflation under control by raising interest rates sharply since July. The key interest rate in the euro area, which was frozen at a record low of zero percent for years, is now 2.0 percent.
Even after the interest rate hikes, the relevant key interest rate is “still in the expansive area,” said Nagel. The deposit rate that financial institutions receive from the central bank for parking excess funds and which is considered the most important interest rate on the financial market is currently 1.5 percent. In June, this was still minus 0.5 percent – which meant penalty interest for the institutes.
According to Nagel, it would be wrong to wait with further decisive steps for fear of an economic downturn. The longer inflation remains high, the greater the risk that long-term inflation expectations will get out of hand. “This must be prevented,” demanded Nagel.
At a level of 1.5 percent, the rate is now on the verge of the so-called neutral interest rate, which neither slows down nor encourages an economy. Because most estimates by economists for the neutral interest rate are between 1.5 and 2.0 percent. After an expected interest rate hike in December, the ECB’s monetary policy stimulus measures should then come to an end.
For Knot it is clear that the interest rate level has to be raised to the restrictive range in order to curb the escalating inflation.
(Photo: Reuters)
The head of the Dutch central bank, Klaas Knot, also assumes this. He expects that the interest rate decision at the next meeting in December will already be there. “Then we will no longer stimulate economic growth, but we will not slow it down either,” said Knot. However, this is only “halfway”. This offers the opportunity to determine further strategy. For the ECB it is clear that the interest rate level has to be raised to the restrictive range in order to contain escalating inflation.
Because it is important to dampen economic demand: “Our reaction must be decisive,” said Knot with a view to the risk of inflation. It is still uncertain how fast the ECB will be on its way to raising interest rates and how much the economy will ultimately have to be slowed down. The further the ECB pushes the interest rate level into the restrictive area, the more likely it becomes that the rate of increases can be slowed down. “In any case, the ECB will be guided by the idea that the risk of persistently high inflation must be ruled out.”
Focus on reducing bond holdings
Lagarde also made it clear in her speech that the ECB will also tackle the reduction of its bond portfolios, which have swelled as a result of the years of purchase programs. “Interest rates are and will remain the most important tool for adjusting our policy course. But we also need to normalize our other policy instruments, thereby increasing the momentum of our interest rate policy,” said Lagarde.
Nagel confirms the plans to reduce the high bond holdings. “In my opinion, early next year we should start reducing the size of our bond holdings by no longer fully reinvesting all maturing bonds,” said the Bundesbank President.
The central bank balance sheet of the ECB has swelled to almost nine trillion euros in the course of years of massive bond purchases. In the professional world, reducing total assets by reducing bond holdings is referred to as quantitative tightening. “The additional tightening would help bring inflation down.” And it would underscore a firm determination to bring inflation back on target.
In December, the ECB will decide on important decisions, said Lagarde. The euro central bank is initially keeping an eye on the bond holdings from the older APP bond purchase program, with which it wanted to boost the economy and inflation from 2015 onwards. According to ECB deputy head Luis de Guindos, the central bank wants to start shrinking in the coming year.
Christine Lagarde promises more interest rate hikes
The ECB wants to continue with the flexible reinvestments in the PEPP pandemic purchase program, as Lagarde said. For this purchase program, the ECB has so far promised that expiring bonds will be completely replaced by at least the end of 2024.
Deutsche Bank boss Christian Sewing spoke at the banking congress about the financial challenges for the next few years. An efficient capital market is urgently needed for this. “We need a 2030 Agenda for Europe. And the very first step must be that we finally create a real European home market,” said Sewing. “Unfortunately, given the lack of political will or lack of unity in the EU, even at best, it will take many years to complete the Capital Markets Union.”
The capital markets union is essentially about removing bureaucratic hurdles between the individual EU countries in order to give companies more opportunities to raise money. The EU Commission’s plans for a capital markets union have been on the table since September 2015, but implementation is faltering.
Without a significant increase in private sector investment, Europe cannot be competitive, Sewing warned. “We will neither master the sustainable transformation nor be able to keep up technologically,” said Sewing. “That’s why it’s so important to finally push ahead with the capital markets union in order to create a liquid and attractive market for domestic and foreign investors,” warned the Deutsche Bank boss.
“Europe’s strategic autonomy is not possible without strong banks that are fully capable of supporting the economy in all situations – and that are competitive on a global scale,” said Sewing.
(Photo: Reuters)
Commerzbank boss Manfred Knof also emphasized at the event that Europe needs more private capital from outside in order to achieve its climate goals and remain competitive. The banks alone could not finance the transformation.
“Europe’s strategic autonomy is not possible without strong banks that can support the economy in all situations with full force – and that are competitive on a global level,” affirmed Sewing, who is also President of the Association of German Banks. “It is becoming increasingly clear that the current regulatory framework is doing little to strengthen European banks.” Regulation in Europe must be readjusted.
Sewing also warned of the loss of financial sovereignty. This would be just as bad as the energy dependency that Europe is currently suffering from. The financing of the transformation requires an urgent change of course if Europe’s future does not want to depend primarily on foreign banks. “No one should take this risk lightly,” warned the Deutsche Bank boss.
Lagarde defends strong regulation
Sustainable finance has become an important area for banks, but Sewing says the region’s leadership in this area is under threat. “Europe will lose its leadership in financing sustainability if regulation continues like this,” Sewing said. The region lacks the capital and financing structures to cope with this task on its own.
Christine Lagarde defended strong regulation in an environment marked by deep uncertainty. “Against such a backdrop, a watering down of regulation would expose banks to further shocks,” said the ECB President.
More: It’s time for a real Capital Markets Union