FRANKFURT (Reuters) -The following is the text of a Reuters Interview with ECB board member Isabel Schnabel.
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Q: Could you give us your assessment of economic developments since your June projections? How is the euro area doing compared to your baseline?
A: Incoming data have confirmed the resilience of the euro area economy. Over the past one and a half years, the euro area economy has grown by around 0.3% per quarter, which is broadly in line with potential growth. This is quite remarkable given all the economic and trade policy uncertainty that we’ve seen. It underlines that the euro area economy has been more resilient than expected.
This also suggests that recent strong GDP growth is not mere frontloading, but points towards a more fundamental improvement in underlying growth dynamics. In fact, the recovery reflects robust growth in domestic demand, supported by easier financing conditions, and this has counteracted the recent decline in net exports.
Going forward, some of the factors that may have been holding back economic growth are going to turn more supportive. In particular, trade policy uncertainty has declined significantly due to the trade agreement, with the agreed tariff rates being not far from our June baseline. In addition, we are expecting a significant fiscal impulse.
All this is in line with recent purchasing managers’ indexes (PMIs), which point to a further improvement of economic activity.
And finally, the global outlook is also brighter than it was in the June projections, because both China and the United States are showing greater resilience.
Q: How do you see the inflation outlook?
A: Inflation is developing broadly as expected. It’s hovering around 2%.
What’s important is that we cannot expect inflation to always be at 2% in a world that is characterised by more frequent supply-side shocks. Looking ahead, we are going to see some volatility, and the inflation profile over the next year is going to be significantly affected by recent swings in energy prices, leading to base effects, and by some one-off governmental measures.
Monetary policy can do very little about this short-run volatility. We must focus on medium-term inflation. This is our yardstick. And medium-term inflation is projected to be around 2%. This is also in line with ECB surveys, such as the Survey of Monetary Analysts and the Survey of Professional Forecasters, which show that the distribution of expected medium-term inflation outcomes is increasingly centred around 2%, with only limited shortfalls over the shorter term. So there seems to be a growing conviction that with our current monetary policy stance, we will be able to secure price stability over the medium term.
Q: How do you see the balance of risk around inflation?
A: I continue to see the balance of risk as being tilted to the upside, for several reasons.
One is food prices. Food price inflation is at its highest level since March of last year, partly driven by the occurrence of extreme weather events. Import food price inflation stands at a high level despite the appreciation of the euro. Food prices are particularly important because they are relevant in shaping households’ inflation expectations.
The second factor is the exchange rate. It’s conceivable that in the current environment of robust domestic demand, the exchange rate pass-through to consumer prices may be lower than assumed in our standard elasticities.
The third factor is tariffs. I continue to believe that tariffs are on net inflationary. Retaliatory tariffs are off the table for now. At the same time, we are seeing that the impact of uncertainty on demand has been smaller than thought. And of course, uncertainty itself has come down.
The most important point is that supply-side effects are typically not captured in the standard models. If you have an increase in input prices globally due to tariffs, and these propagate through global production networks, this will increase inflationary pressures everywhere. Moreover, you could see supply chain disruptions as we’ve seen in the case of rare earths. We’re also seeing them with the end of the de minimis exemption for small packages in the United States.
All in all, these add up to a moderate inflationary impact. This is in line with a recent article published by the Bank for International Settlements.
The fourth factor is fiscal policy. We are expecting a significant fiscal impulse, which directionally is inflationary. The size of that effect will depend on whether the economy or certain sectors are going to hit capacity constraints.
Q: How concerned are you about the level of the euro’s exchange rate?
A: I don’t comment on the level of the exchange rate.
But if you take a historical perspective, the moves in exchange rates that we’ve seen are not particularly large, also against the US dollar, which is the most important currency because of its role in invoicing.
Second, the pass-through of the exchange rate appreciation may be smaller than suggested by standard elasticities. The pass-through often tends to be smaller for currency appreciations because of downward price rigidities. It also matters what is driving the exchange rate appreciation. Currently, it is driven to a large extent by a reassessment of relative growth prospects. In that case, the pass-through also tends to be smaller.
And finally, when we think about competitiveness what matters is real exchange rates. In real effective terms, the euro is well below previous peaks and hasn’t moved all that much.
Therefore, I am less concerned about exchange rate developments.
Q: Some have argued that higher US tariffs would encourage China to dump surplus goods elsewhere, including the euro area, dragging down prices. Do you see any of that taking place?
A: Higher US tariffs lead to a general shift in global trading patterns. For example, US importers may turn away from Chinese goods, which may actually benefit euro area exporters.
But if there is an excess supply in China, the Chinese exporters may have an incentive to lower their export prices to regain losses in global market shares. When you look at Chinese overall export prices, however, it turns out they have recovered and are now rising again for some typical consumer goods like electronics. It may be that cutthroat competition in China is hitting constraints, as acknowledged by the government’s recent “anti-involution” campaign, posing a limit to lowering prices. Euro area import prices from China are low but they don’t show any particular new pattern. Thus, so far we have not seen signs that China is dumping goods on the euro area at a large scale.
Moreover, the volumes are too small to have a first-order effect on inflation. For example, the share of Chinese imports in German consumer goods is just 1.4%.
Q: You said there was a growing conviction that the current monetary policy stance will achieve price stability. Could you unpack this? Does this mean you see no need for any further rate cuts based on information available today?
A: At the current juncture, I see no reason to adjust the policy stance in either direction. Interest rates are in a good place. Medium-term inflation is projected to be around 2% and inflation expectations are anchored. We are at full employment and the economy is growing around trend.
Looking beyond September, it is important to acknowledge that we cannot fine-tune inflation in a way that it is always at 2% in a shock-prone world. That’s a point that was also stressed by President Lagarde in a speech earlier this year. This means that the ECB should only react to material and persistent deviations of inflation from target that threaten to destabilise inflation expectations and therefore put into question medium-term price stability. We can tolerate moderate deviations of inflation from target in either direction.
So, in the absence of large shocks, I see no reason to adjust the policy stance.
Still, your projections do incorporate one further rate cut and the market is still mostly pricing one in. So, are you arguing that you can maintain 2% even if you don’t cut once more?
Models cannot statistically distinguish one cut more or less. It’s not like an engineering problem. So we have to look at the broad economic and inflationary environment and our medium-term projections for inflation. And we must take a stand on where we are on interest rates. I believe that we may be already mildly accommodative and therefore I do not see a reason for a further rate cut in the current situation.
What would you need to see to change your mind? And perhaps if I can unpack the question, do you feel you have learned enough, for example, about tariffs in the few weeks that have intervened between the deal and now.
We remain attentive to new developments. With every new data point, we are learning something. And if there were news that would fundamentally change my view of medium-term price stability, that could be a reason to adjust the monetary policy stance. But at the moment, I just don’t see that. On the contrary, the euro area economy has been more resilient than expected despite the tariffs.
At what point would you start to get concerned about inflation being below target? What’s sort of the trigger that would change your own thinking?
This would very much depend on whether I see any indication that there is a de-anchoring of inflation expectations to the downside. Given the upside risks to inflation that I mentioned and the relatively high inflation of salient goods like food, I find it highly unlikely that there’s going to be a de-anchoring of inflation expectations to the downside, especially after these many years of too high inflation. Let me add that when you look at firms’ selling prices, you don’t see any indication of disinflationary pressures, neither in the manufacturing nor in the services sector.
Q: Negotiated wages rose by 4% in the second quarter. How do you interpret that acceleration?
A: Wage data tend to be volatile, and we should focus on the overall trend, which continues to point to a deceleration. The sharp increase in negotiated wages that we’ve seen was driven by one-off payments in Germany in the first quarter of last year, which compressed the first-quarter number. If you look at the series excluding the one-offs, you get a more realistic picture and you see that negotiated wage growth has plateaued at an elevated level and that it has now decreased slightly from 4.4% to 4.3% in the second quarter. By contrast, if you look at compensation per employee, you can see that the decline there already started in 2023, and it now stands at a level of 3.8%. Our forward-looking wage tracker and our surveys suggest that wage growth is going to decelerate and this is also embedded in our projections. That being said, wages remain one of the main cost drivers for firms, in particular in the services sector.
Q: Is there any doubt in your mind that perhaps we haven’t seen tariffs bite quite yet?
A: Of course, the effects of the tariffs still have to fully play out. The most direct impact will be on the United States. But even there we have seen some resilience. However, we are starting to see the tariffs having some inflationary impact there, especially among more tariff-sensitive goods, like consumer electronics and furniture. I expect these inflationary pressures to increase over the coming quarters because firms may feel the cost increase more and more as their inventories are exhausted. And firms may also be less and less willing to absorb the higher costs in their margins. This is something that we have to watch very carefully – one of the lessons from the pandemic is that it’s very hard to insulate ourselves from global inflationary developments.
Q: And yet, the Fed has signalled it may well cut rates this month, not raise them. So, they don’t seem as concerned about inflation. How does that affect your calculus?
A: The US Federal Reserve System is firmly focused on making sure that the tariffs, and the associated increase in prices, do not turn into more sustained inflation dynamics.
As regards the impact on our monetary policy, we have demonstrated in recent years that we can run our monetary policy independently from the Fed, even if the Fed’s policies feed into our decisions through the assumptions underlying our projections and analysis. In any case, lower US rates would imply a reconvergence of interest rates after a period of divergence because the ECB has cut interest rates twice as much as the Fed.
Q: Markets are starting to price in the Fed coming under political pressure. You can see it in the price of gold, in long-term US bond yields and in the price of Bitcoin. The market is pricing in a Fed that is – for political reasons – structurally more dovish. How does that notion of a structurally different environment for central banks, where the biggest and most important central bank is under political pressure, if not under political influence, affect your thinking?
A: History is very clear about the benefits of central bank independence: it lowers risk premia and it eases financing conditions for households, firms and governments. So, any attempt to undermine central bank independence is going to lead to an increase in medium and long-term interest rates.
The ECB is one of the most independent central banks in the world, protected by the European Treaties. Recent capital flows show that this benefits the euro area. Following the April tariff shock, we’ve seen large capital flows into the euro area from global investors, both in bond and equity markets. We’ve also seen that non-euro area firms have increasingly issued bonds in euro. This shows that there is a lot of trust in the euro. It also shows trust in the ECB’s independence.
To foster that trust, we have to follow our mandate and ensure medium-term price stability. This is the best protection against any threats to our independence.
Do you see a risk of a global race to the bottom as more central banks have to, or try to, follow the Fed in lowering rates?
Not at all. On the contrary, a more fragmented world with a less elastic global supply, higher fiscal spending and ageing societies is a world with higher inflation. So I think the point where central banks around the world start to hike interest rates again may come earlier than many people currently think.
Q; If the Fed’s independence is curtailed and therefore there’s a bit of excess inflation in the United States, some of that would transmit over here, which would also put the ECB under pressure. So wouldn’t there be a direct consequence for the ECB from a loss of Fed independence?
A: If the loss of Fed independence happened – and I very much hope that it doesn’t – this would be very disruptive for the global financial system and it also would have an impact on the ECB.
The precise impact would depend on how that scenario would play out. One of the big questions is whether the US dollar can maintain its current status. Generally, I’m inclined to think that it can. But if it weren’t able to, then it’s not clear what would happen in the global financial system because there is no clear alternative. I do think that the euro would benefit from that, but the global financial system is not in a situation where it could easily live without the US dollar as the key currency.
Q: Quite a few of Europe’s central banks hold gold reserves in New York, mostly at the Fed. Given talk of putting tariffs on gold and about the Fed’s independence, do you think it remains appropriate for central banks across the Eurosystem to hold their gold reserves in New York, or should there at least be a discussion about repatriating them?
A: don’t comment on our gold holdings. But you can be sure that if there were any concern about the safety of our reserves, we would do something about it.
Q: You said the euro would benefit from the dollar losing its status but, as we speak, France is engulfed in a repeat of last year’s political and budget crisis. That is a reminder to international investors that the euro is still architecturally weak because of its 20 different budgets and sovereign debts, with the ECB acting as a safety net with its Transmission Protection Instrument (TPI). How involved should the ECB be in politics, and in French politics in this case, if it wants to preserve its independence?
A: I think you’re over-interpreting what is happening at the moment. What we’re seeing in France is not entirely new. France is facing a challenging fiscal situation. There’s a need to consolidate, while at the same time there’s a need to foster potential growth in a politically charged environment. So what we’re seeing is mainly an issue that relates to France. I don’t think it has wider implications for the euro.
Q: Would it be a show of independence not to activate the TPI?
A: There are clear rules about when the TPI can be activated. It’s there to deal with unwarranted and disorderly movements in sovereign bond markets. We’re not seeing that at the moment. We’ve seen some repricing, which just means that financial markets are functioning in the way that they should. I find it far-fetched to talk about the TPI at the moment.
Q: Turning to the new operational framework, how are banks coping with the reduction in liquidity? When should we start to expect a debate to begin on the review scheduled for next year?
A: The framework we decided on in March 2024 is working as intended and it has been well received by financial markets and banks. It seems that globally many central banks are moving in a similar direction.
Under the new framework, the normalisation of the balance sheet has proceeded smoothly. Market financing of banks has picked up and there’s also redistribution of liquidity across the system.
For now, the recourse to our standard refinancing operations remains small because excess liquidity is still ample and it’s cheaper for banks to fund themselves via the markets than by taking recourse to our operations.
Eventually, that’s going to change and the recourse to our operations will pick up. Banks should consider the standard refinancing operations to be an integral part of their day-to-day liquidity management and an important component of a diversified funding mix.
However, excess liquidity has come down somewhat more slowly than expected as a result of some autonomous factors. For example, there has been weaker growth in the demand for banknotes. There has also been a stronger decline in government deposits.
That means that we have more time to think about whether we need to adjust any of the parameters of the operational framework, and to think about the design of the structural operations. These operations are going to make a significant contribution to the structural liquidity demand by banks, but they will only be introduced once our balance sheet has started to grow durably again. And this presupposes that there is regular access to our weekly operations because these provide the marginal unit of central bank liquidity on demand. Only once that has happened will we introduce first the structural refinancing operations and then, at a later stage, the structural bond portfolio.
Q: When do you expect that to happen, indicatively?
A: It’s hard to say because there’s quite a bit of uncertainty about the development of excess liquidity. The nice thing about our framework is that we don’t need to predict the exact timing because the system adjusts endogenously. But we have to be prepared, and the banking sector needs clarity on what to expect. This is why we should start talking about the design of the structural operations well ahead of the point when they are actually introduced.
Q: So is the next review still set for 2026?
A: We haven’t confirmed the precise timing but the work is certainly going to start next year.
Q: You said two years ago Europe was behind in terms of innovation and technological adoption. In the meantime, the AI revolution is taking place in the United States and China, and Europe is not even on the map. What role can Europe hope to play in this transformation?
A: Europe can only play a role in that transformation if it gets its act together and becomes serious about European integration. A European savings and investments union and, in particular, a capital markets union, play a crucial role here. It’s not that we don’t have innovation; we have a lot of innovation, but it’s very national. It’s hard for start-ups to scale up across Europe because there are 27 different regulations. This has to change. It’s why I’ve always been a big supporter of what’s called the 28th regime – something also recommended in the reports by Mario Draghi and Enrico Letta. It’s the idea that you could have a specific regime – potentially only for innovative companies – where companies can operate across Europe under the same set of rules. This would make it much easier to scale up. And for me, that is the crucial point if we want to be a serious player in innovation.
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