Philip R. Lane: Interview with Financial Times

27 May 2024

Let’s start with the latest euro area wage data, which showed collective wage growth accelerating in the first quarter. Is this a worry?

At the ECB we have developed a forward-looking wage tracker, which has anticipated the first-quarter number pretty well. We have detailed country data, details about private sector versus public sector, the nature of one-off payments, etc. It is also important to take into account that wage contracts are often multi-period. We can extract what was paid according to these contracts in the first quarter, but also what will be paid later in the year, into next year, and so on.

Looking at the full detail, the overall direction of wages still points to deceleration, which is essential. Deceleration does not necessarily mean an immediate return to steady state. This year the adjustment is clearly quite gradual. In our projections we also had a fairly gradual pace of deceleration − this year was not seen as a normal year. Next year is seen as lower than this year, but we think wages will normalise only in 2026. So we are a step along this journey. We also have to look at the wage data in the context of the price data, as the concern behind wages is what higher wages mean for prices.

Services inflation is not yet in a normal place and that connects to the fact that wage inflation still has a lot of catch-up going on because of the staggered way in which wages are reset. But in the April data services inflation has started to come down.

More generally, we said inflation is going to bounce around this year, and wages are also going to bounce to some extent. But there is a downward trend, even if basically there will be fluctuations around that trend.

Have the latest data changed your view on the likelihood of an interest rate cut at next month’s meeting of the ECB’s Governing Council?

The June meeting is only a couple of weeks away, but we will still get more information by then. We will have the May inflation data, which are important, and there will be some national GDP and compensation per employee data. But it is probably fair to say that, barring major surprises, at this point in time there is enough in what we see to remove the top level of restriction, being at 4 per cent. The data flow over the coming months will help us decide the speed at which we remove more restrictiveness.

How about for the rest of this year, will you be taking a cautious approach given how wages are still rising rapidly and services inflation is still well above 2 per cent?

Things will be bumpy and gradual. The best way to frame the debate this year is that we still need to be restrictive all year long. But within the zone of restrictiveness we can move down somewhat. We don’t need the data to say normalisation is a lock. What we do need the data to say is: is it proportional, is it safe, within the restrictive zone to move down.

Under the baseline forecasts, next year, when we expect wages to have visibly decelerated, when some of the base effects of fiscal measures which are pushing up inflation this year have faded out, then there will be a discussion about normalisation. Unless a shock arrives, the debate for this year is about staying restrictive. But exactly what level of restrictiveness is needed will be data-dependent.

We need to use this time between now and the end of this year − because we have quite a few meetings to go this year − for thinking about what are the thresholds and what are the triggers for moving down the rate path within this restrictive zone. That will be the debate.

More analysts are predicting you will not do back-to-back rate cuts in June and July. Are they right?

It is not particularly helpful for me to get involved in that meeting-by-meeting updating of what we are going to do. That is secondary or tertiary to the overall issue, which is having a sense that the wage data will decelerate fairly gradually. We have already been clear that, because of base effects, inflation is going to fluctuate around current levels for the rest of this year, so there is not a massive linear trend to guide the meetings.

The scale of the inflation we still have in services and domestic inflation clearly means we need to be restrictive this year, because we need to make sure that the still significant amount of cost pressure does not fuel price increases too much. That is what a restrictive monetary policy does; it says demand is going to be sufficiently moderate that firms will think twice about trying to pass on cost increases.

In terms of the real rate, with inflation coming down compared to where we were in the autumn, you can have the same amount of real restriction with a lower nominal rate.

Next year, with inflation visibly approaching the target, then making sure the interest rate comes down to a level consistent with that target − that will be a different debate.

But between now and this time next year, I’m sure there will be shocks. There will be shocks in Europe and shocks around the world. So I would not overestimate or overly focus on the neutral rate debate. Because is the world going to be neutral next year? Maybe the world will be calm. But maybe various shocks will arise. We have to think in terms of a baseline, but we also have to be reactive to whatever the world delivers in terms of new economic shocks.

Do you think the last mile − or last kilometre − will be the hardest part of disinflation? There are worries about sticky services inflation, high wage growth, weak productivity − do you share those concerns?

These kinds of concerns explain why I think we need to be restrictive for an extended period. We need to see more progress before we move from maintaining the restrictive phase to thinking about normalisation.

There is still a significant backward-looking element to the inflation and wage process. It is basically saying that the massive shock to inflation we had in 2021 and 2022 is triggering a strong second round and a significant third round, which is less significant than the second round. Some people are getting their second wage deal since the inflation shock, which may still be significant but less so than the first. What we have seen, for example, is that insurance rates went up quite a bit at the start of this year and that is a classic third-round element as inflation pushes up the cost of repairing a house or replacing cars. So we are still working through the full adjustment to the original shock. And the reversal of fiscal support measures in some countries in Europe is also relevant this year.

As that adjustment is still taking place, you have to make sure it is weakening over time. The restrictive monetary policy is putting guard rails around that process, to make sure it is not converting into inflation that shows no sign of decelerating. If that happened, if inflation got embedded at some distance from the target, that would be very problematic and probably quite painful to eliminate.

Is there a limit to how much the ECB can diverge from the US Federal Reserve on monetary policy?

There are two mechanisms, which run in opposite directions. One mechanism is: if global investors can receive a higher yield in the United States, by arbitrage that will put upward pressure on the longer end of the European yield curve. That mechanism means that for any interest rate we set, you get extra tightening from the US conditions. All else being equal, if the long end tightens more, then how you think about the short end changes.

In the other direction there is the exchange rate channel. Clearly there has been very little movement here. But imagine a scenario where the rate paths were so different that the exchange rate moved in a more significant way. We would take that into account. But we are not a small open economy in the euro area. A lot of exporters to the euro area price in euro, so if the exchange rate moves the initial hit often is in their profit margins. But eventually they would raise the prices they charge in euro. It takes place over a multi-year timeline. In any given year, that currency depreciation will be visible in the inflation data but it is fairly small. It would have to be a pretty big exchange rate movement to really have a strong influence on inflation itself. But it would be a factor. And there may be depreciation against the dollar, but we are appreciating against other currencies like the yen. So you also need to think about the trade-weighted basket of currencies.

Then, if the US economy is growing more strongly that will put upward pressure on global prices, because they might demand more commodities and goods from around the world. But while the United States grew strongly last year, there are signs the US economy is slowing down. In the other direction, there are signs the European economy is starting to grow. So in some sense this stark differential between the US and European economies may narrow over the next year or two.

If you do cut rates in June, is it risky to be the first major central bank to cut rates, or is it a source of pride?

I don’t think it is useful to think about it in relation to other central banks. Also keep in mind that in terms of the global central banking community, there are some central banks that have already moved.

There are global factors but we should not overstate the degree of integration across the economies. Each central bank has to address the circumstances it faces. We're setting the policy for a very large fraction of the continent of Europe.

And an important reason for the lower inflation pressure in the euro area has been the very negative terms of trade shock and the very muted economic growth we have had. Dealing with the war and the energy problem has been costly for Europe.

Famously, central bankers aspire to be as boring as possible and I would hope central bankers aspire to have as little ego as possible but it has been important to reassure people that we will make sure inflation comes back to 2 per cent in a timely manner. In our December 2022 forecast we did say that a lot of the inflation would fade away in the course of 2023. It has been our mantra that it is not a 1970s-style inflation episode. To support this process, to make sure that the very large temporary shock in inflation did not get embedded, we did have to move to a restrictive policy and maintain it. But in terms of the playbook of how to contain this very large surge of inflation, we did do quite a bit. And inflation has been coming down.

That said, it is not the time to make conclusions, because we are not at target yet. We are in a transitional phase where we need to remain restrictive for a good amount of time to come. But in terms of that first step, in saying that maybe it is time to come away from that peak, that is a sign that monetary policy has been delivering in making sure that inflation comes down in a timely manner. In that sense, I think we have been successful.

How will you determine where the neutral rate is and do you think it has increased recently?

Once we move from being restrictive and think we are on a normalisation phase, and with the caveat assuming no big shocks derail that process, we will be searching for that neutral rate. An issue of the ECB’s Economic Bulletin published a few months ago presented a range of different estimates. At one end there were estimates where the real neutral rate was negative. Then you had estimates centred around a real rate around zero, so a policy rate around two. Then you had estimates that were more positive than that. When you think about the zone of plausible neutral rates, how much attention you pay to having a negative neutral rate, that part of the zone is not so current. Then the question is whether we should focus on a zone where the real neutral is something in the range of zero, or a very mildly positive real rate, versus a much more significantly positive real rate.

We have a fairly weak investment profile in Europe. Of course, without Next Generation EU it would be weaker still. Right now we also have a profile where the savings rate is quite high in Europe. The question is basically: where do we think investment is going and where do we think savings are going, and within that where do we think the desire for safety is going in terms of the risk-free rate on government bonds.

In order to see a very large decline in savings, you’d have to see a lot more confidence. In order to see a great big surge in investment, you’d have to see some triggers. Let me mention two forces that could move in that direction. One is a vigorous green transition and two is if the world converges on the conclusion that there are near-term possibilities from generative AI opportunities. But this is where you would need to see more evidence than we have right now.

If we saw a surge of investment that would underpin the transition in the economy, that would be very welcome. The interest rate consequences of that would be clear.

What about the savings rate − is that likely to change?

The savings rate has a precautionary element, where as people see their real incomes go up they should have more confidence in consuming. So there could be a mild improvement in the savings rate as the economy picks up. But to have a really big change in the savings rate, as in a much lower savings rate, a big factor is the level of public deficits. One reason why the United States has a very low savings rate is the very large US fiscal deficit. So there is a tension between clearly wanting national fiscal policies to have a decline in debt levels versus wanting to have a decline in the savings rate.

The United States recently increased tariffs on a range of imports from China and urged Europe to follow suit. What would it mean for inflation and monetary policy if we had a global trade war?

Right now it has injected a lot of uncertainty. There have been measures, but it is not a full-scale descent into trade war. But the uncertainty about the future must be holding back investment and must be feeding precautionary savings by households. So in that sense, it must be slowing down the economy and it must be disinflationary. But I think there are two ways we have to think about it from an inflation point of view in either direction.

One is the trend for energy prices. What happens if there is a really disruptive energy shock? We’ve been through one in Europe. If we saw a major interruption of the supply of energy to Europe that would be very consequential. But that also depends on European policies. How quickly can we build up the energy union in terms of efficiency of the network and the resilience of supply.

Second, if we do have a more fragmented world economy, then I think the biggest issue is the volatility of inflation. If you have the world as a supplier to you, then if Europe increases demand it can increase imports without pushing up price pressures. But if the European economy increases demand in a more fragmented world it would put more pressure on costs. That works in both directions: a surge in demand might increase inflation more quickly; a decline in demand might reduce inflation more quickly. We could be in a world where inflation is more volatile. That’s why we need to be data-dependent and make sure monetary policy is responding in either direction.

What do you think about the idea of the ECB doing something similar to the Fed’s “dot plot” that shows where policymakers think rates will go?

Of course we look at many simulations of the future rate path. But I think philosophically it is important to maintain maximum agility, which is to say we make decisions meeting-by-meeting. There is a case for central banks to publish what they expect to happen in terms of the rate path. But in the end agility is maximised by saying we take decisions on a meeting-by-meeting basis, in the context of everything we've been presented with by staff in terms of all possible futures.

Now that your forecasts are more accurate are you shifting to put more weight on them in deciding policy rather than by assessing backward-looking data?

In September 2019 already, we moved to decision-making which not only looked at forecasts but also at underlying inflation in the forward guidance. So throughout my time here at the ECB we’ve always been two-handed about the forecasts versus underlying inflation. I would say it is about filtering out the backward-looking element of the data and saying, what do the latest data tell us about the future, which is why we look at the underlying element of the data. As we get closer to the target it is bumpy and there is less information in the latest data point. But I think we should always be two-handed about it. The forecast is the most comprehensive way to guide the future because our staff integrate everything. The incoming data help us weigh up the risks around that forecast that need the most attention.