FRANKFURT – The European Central Bank will exercise great caution over withdrawing any stimulus measures and may hold off on making a call on the future of its pandemic-induced bond purchase program at its September meeting, a top policymaker has signaled.
In an interview with POLITICO last week, ECB Governing Council member and Bank of Finland Governor Olli Rehn warned that the bank “should avoid the mistakes that were done in 2011 with early rate raises” amid inflation concerns, noting that “the role of monetary policy is to ensure that we will not face a sudden setback in economic recovery.”
ECB tightening moves in 2011 were widely blamed for exacerbating the ensuing sovereign debt crisis. The Frankfurt-based institution has since been struggling to convince investors that it won’t again jump at fighting inflation prematurely.
The ECB holds its next monetary policy meeting on September 9 and is widely expected to discuss the future of its asset purchase program launched in reaction to the pandemic’s economic fallout. At this meeting, the Governing Council will have updated growth and inflation data available, and policymakers tend to reserve big policy decisions for meetings that also publish new projections.
It’s also coming at a time when the U.S. Federal Reserve is considering “tapering,” or unwinding its massive support program, provided that job growth is strong. Those expectations were boosted Friday by comments from Fed Chair Jerome Powell.
Whatever the ECB’s September announcement, getting the economy back into gear can’t rest only on the central bank, said Rehn, who compared its role to the last line of defense on a football pitch. Governments also have to play their part in the game to ensure growth.
And with respect to inflation, an important driver is that employees must demand more pay. “Wage growth is the critical factor in core inflation,” Rehn said.
With current wage growth still tepid, however, the ECB will be compelled to keep interest rates low and continue buying bonds, he said: “The medium-term inflation outlook is probably the same as in the June forecast, according to my reading. This means that inflation remains well below our new symmetric 2 percent target, which justifies the continuation of the accommodative monetary policy stance.”
Eurozone inflation rose to 2.2 percent in July, exceeding the central bank’s 2 percent target. But core inflation — which excludes the more volatile categories of food and energy and is usually the more meaningful statistic for monetary policymakers — stood at just 0.7 percent.
Rehn stopped short of revealing whether he expects a decision on phasing out the so-called PEPP crisis program at the September meeting. The ECB has earmarked €1.85 trillion for purchases under the PEPP, of which it has so far spent around €1.3 trillion.
The earliest possible date the bank has given is the end of March 2022, but it pledged that it will continue purchases “until it judges that the coronavirus crisis phase is over.” However, in Rehn’s view, it’s too early to make that call.
“There is still plenty of uncertainty in the global economy and in the euro area, mainly because of the spread of the Delta variant and because of the slow pace of vaccination in some parts of the world,” he said. “So we are not out of the troubled waters yet.”
Looking ahead, he called for a smooth transition into a post-PEPP environment, echoing remarks from other Council members such as Bank of France Governor François Villeroy de Galhau. Their bottom line is that the ECB can only wind down its crisis program if other policy tools are adjusted to avoid disruptions. For instance, policymakers could boost asset purchases under previously existing programs such as the APP.
“It is always essential to have a smooth transition from forceful economic policy measures and that goes for the PEPP as well,” Rehn said. “I’m certain that we will in due course, once the time is ripe, find a viable and workable solution to this challenge as well.”
In the meantime, Rehn said, if the U.S. Federal Reserve causes any market disruption when it winds down its own pandemic support programs and makes financing conditions in the eurozone less favorable, “the Governing Council stands ready to adjust and use all of its instruments, as appropriate, to ensure that inflation stabilizes at its 2 percent target over the medium term.”
Window of opportunity
Rehn’s comments stand in contrast to his position when he served as European commissioner for economic and monetary affairs during the eurozone crisis and had a major hand in the resulting austerity policies — a period that U.S. economist and columnist Paul Krugman famously dubbed “the Rehn of terror.”
Rehn rejects that assessment. “If the impression is that I was a single-minded defender of austerity, it is simply wrong,” he countered. In his view, it wouldn’t have been possible for eurozone member countries to have been as generous on the fiscal side then as they can be now, because interest rates were higher and borrowing costs varied much more among member countries — whereas now they are consistently low.
At the time, interest rates were “at 6 percent, today they are around 0.6 percent,” he said referring to Italian 10-year bonds. “That makes a dramatic difference if you have hundreds of billions in public debt.”
This time around, Europe must not waste the opportunity created by the ECB’s easy monetary policy, the EU’s massive fiscal stimulus package and the dramatic fiscal boost in the United States that President Joe Biden is trying to steer through with his thin majority in Congress.
“We have … a window of opportunity to invest and reform our economies towards a green and digital transformation and higher employment rates in the next couple of years,” he said, pointing in particular to Italy’s potential transformation under Prime Minister Mario Draghi.
If Europe doesn’t seize the chance to enact deep economic reforms and commit to investment, he added, it runs the risk of seeing sharply diverging spreads once again.
In any case, sovereign borrowing costs will go up eventually and governments should be prepared for that, Rehn said. “One day we will see the rates rising,” he warned.
Looking at the region’s fiscal rules, Rehn said he supports a reform of the Stability and Growth Pact, which calls for eurozone members to stick to debt and deficit targets but has long lacked meaningful enforcement tools. However, he cautioned, this effort shouldn’t “throw out the baby with the bathwater.”
The inherent tension between debt reduction and fiscal flexibility could be reconciled if Europe practiced “comprehensive Keynesianism,” in his eyes, rather than half measures. This means that policymakers should be ready to cut public spending when times are good so that they have more room to maneuver during recessions, he explained.
“I would like to keep an open mind, but the proposal of [the Commission’s] European Fiscal Board is a good starting point,” Rehn added. This body would set country-specific targets that are realistically achievable, clear spending rules and an element of flexibility under exceptional circumstances. Currently, the fiscal rules call for all member countries to limit budget deficits to 3 percent of GDP, and public debt to 60 percent.
Rehn left open whether he may help to shape Europe’s future in yet another role as president of Finland, which is holding elections in 2024. In a recent newspaper poll, which asked respondents who they preferred if there was a direct vote, he emerged as the favorite.
“I’ve always loved policy more than politics,” he said. “Presidential elections are still a long way away. In these trying times, my focus is squarely on monetary policy and dealing with the current crisis and its consequences.”
Clarification: This article has been updated to note that it was interest rates that were around 6 percent during the eurozone crisis.
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