Member of the Board Tuomas Välimäki
Bank of Finland
Interview with Reuters, by Balazs Koranyi and Anne Kauranen
Published 16 January 2024

Q: What’s your take on inflation developments since your last policy meeting?

A: Inflation certainly has decreased rapidly from its peak, thanks to low energy prices, and also due to our decisive monetary policy measures. We see core inflation slowing down and gradually approaching our goal. Policy has evidently been effective in dampening the inflation pressures and anchoring inflation expectations. So, we are on the right track.

Having said this, inflation and especially core inflation at 3.4%, remains faster than we can accept. Thus, restrictive monetary policy still called for.

Inflation readings have been volatile, especially as a result of the base effects. In December, inflation bounced back somewhat from November levels, mainly on the energy base effect. This year energy inflation is expected to gradually increase into positive territory due to reversal of this base affect. Energy will continue to be a volatile component in inflation throughout the year. That's why we also need to focus on the dynamics of underlying inflation.

Q: The ECB’s chief economist said over the weekend that the bank would be in possession of key wage and inflation data by June. Is that also a significant date for you in assessing where policy is going?

A: I would not want to give any specific date on when we would have enough information to change our view. Forecasting is difficult, especially forecasting turning points. We do analysis on a continuing basis and our views will evolve with incoming data. We'll continue to be data dependent, which is the correct approach to address the uncertainties around the projections.

Q: How do you see the risk to the inflation outlook?

A: We see risks on both sides. We could have a surprising deterioration of the economic outlook, which would then reduce inflation quicker. But there is a lot of uncertainty to the other direction as well. We are not totally on safe ground with wage formation. We need to get core inflation back to our target.

Q: Have you seen any concerning wage data recently?

A: Since our last policy meeting, when we also published new projections, I haven't seen wage readings which contradict our projections.

Wage formation is one of the key issues when assessing the evolution of core inflation this year.  Social partners’ expectation of moderating inflation is a key prerequisite for wage agreements that would be in line with our inflation target.

Thus, preserving the credibility of our inflation anchor is one of the fundamental reasons for us to keep our heads cool and not jump the gun. The history of central banking shows that false starts can be very costly. We need to have enough evidence of healthy dynamics for core inflation and certainly in this regard, the development of wages is crucial.

Q: What do you mean by false start?

A We need to avoid declaring victory over inflation prematurely. It would be better to wait and see how data on wages develop. It’s better to wait a bit longer than doing a premature exit from this restrictive level, and then perhaps to having to do a reversal. I see a clear need to get enough evidence that we are on track.

Q: Where do you think future economic growth will come from?

A: I expect it to start from private consumption. Wage developments coupled with moderating inflation, will increase households’ real incomes and that will be helpful in boosting economic growth. Certainty among investors on the terminal rate has also increased compared to a year ago, which will be helpful. Exports have not been strong lately, but we are expecting a rebound from net exports later this year.

I expect growth to gradually strengthen over the course of this year.

Q: Is a soft landing now materializing?

A: A soft landing in the euro area is my and our baseline for the euro area. As it is also for a number of international institutions such as the IMF or the European Commission. However, it's clear that risks to growth are tilted to the downside, as indicated, for example by PMIs which have remained clearly below 50.

Q: How consistent is your warning against a false start with a market pricing for 150 basis points of rate cuts this year?

A: Market pricing is one thing, and the analyst view is another. Economists’ views differ from the rate path priced into money markets. This suggests a considerable degree of uncertainty among market participants and the distributions around the market prices are wide. Market pricing also has real effects. In Finland, mortgages are floating rate and that's why households are already starting to face looser financing conditions.

We need to get enough evidence and analysis before the interest rate cycle can turn. The evidence from the economy and our projections should show that inflation is decreasing to the level which coincides with our price stability objective in the medium term.

Q: Is the market undoing the ECB’s tightening and thus actually delaying a rate cut?

A: There is logic in that argument. If markets are ahead of policymakers, time will tell who was right and views will converge.

If our baseline forecasts are correct and market rates fall much more rapidly than what is priced into the projections, then ceteris paribus that would lead to higher inflation, and I can understand the logic of saying that it could delay monetary easing. But this is dependent on our forecast being more correct than those of the market, and that's certainly what we believe in.

Q: Finnish wage growth appears to be modest. Do you have an expectation that very large deals will be done elsewhere?

A: Our inflation target is 2% so if you assume productivity growth somewhere around 1%, wages increase around 3% would be consistent with the inflation target. Currently wage increases are higher than that. But as long as this is a lagged compensation of the inflation peak, then it is not indicating a wage-price spiral. But if wage agreements don't come down over time, then there is a such a risk.

In Finland, like in the rest of the euro area, nominal wage growth accelerated significantly in the latter part 2022 but still remained somewhat more moderate than in many euro area countries. However, the nominal unit labor costs here have developed in line with corresponding costs in other euro area countries, as our labor productivity growth has been weaker than elsewhere. The slower wage growth has also been associated with slower inflation. So, when it comes to wages, cost and prices, we've experienced a similar trend as elsewhere.

Q: How do you resolve the anomaly of a tightening labour market during a recessionary period with high interest rates. Labour markets should be softening.

A: The labor market has been robust and unemployment is lower than ever. This is the case in many if not all euro area countries and also applies to others outside Europe. If you compare GDP growth and changes in unemployment, they are not in line with past correlations. This is especially true when you look at unemployment or employment figures. The story is slightly different if you look at hours worked. Still, the labor market has been extremely robust.

Q: Could high corporate margins have a role in this?

A: Consider the fact that many companies before the pandemic faced a shortage of labour, especially skilled workers. So, if you have healthy margins, it is not entirely surprising that companies may have decided to maintain current staffing levels, even if the demand is a bit weak. If everything goes as projected and the landing is relatively soft, then weak demand is short lived and afterwards they again face a shortage of skilled laborers. So, this kind of “labour hoarding” could explain why labour market developmens have been out of line with past correlations.

Q: Do you think the ECB should raise the minimum reserve requirement as advocated by some?

A: I don't currently see any reason to make the minimum reserve requirement an active monetary policy instrument to influence the policy stance. We have our policy rates for that purpose and have other tools as well.

The decision to set the remuneration of minimum reserves at zero in July was aimed at improving the efficiency of monetary policy without weakening its effectiveness.

The ongoing operational framework review will provide a good opportunity also to think about the role of required reserves in our operational framework. The reserve requirement can play an important role in some operational frameworks, whereas they might not be strictly needed in others. So, I think this question should and will be part of the review.

Q: Should the ECB maintain a structural portfolio under its new framework and what should be part of it?

A: Even though our balance sheet is now shrinking, it will continue being larger than it was before the global financial crisis. For example, due to the growth of banknotes in circulation and other liabilities.

In my view it is preferable to use both outright purchases and credit operations on a permanent basis to provide structural liquidity to the banking system. TLTROs and QE may be useful in some circumstances, for example to prevent financial crises or to provide a further stimulus in a liquidity trap, but they should not be mixed with structural liquidity operations.

Structural outright portfolios would provide stable liquidity while structural long-term credit operations could allow some liquidity transformation against less liquid collateral and distributing liquidity efficiently directly to bank, after all, the funding of real economy in the euro area is very much bank based.

So, I see the coexistence of outright purchases and credit operations. But this is not a novelty. We had outright purchases even before the global financial crisis but they were just not part of the monetary policy thinking because they were done as investment operations by the national central banks.

Q: How big should this structural portfolio be?

A: The need for reserves is higher if one wishes to continue pushing the market overnight rate to the deposit facility rate, as we currently do. The need will be lower if one wishes to return to setting the interest rates by a corridor. I can also tell you firmly that the current level of central bank liquidity is not needed to bring overnight rate to the floor. But also, banks’ demand for working balances will be significantly higher than it was before the global financial crisis. The precise calibration of banks’ neutral liquidity needs will change significantly over time and mentioning specific numbers at this stage is not necessary or useful.

I'm confident that we can design a framework that provides us with effective ways to steer money market rates, which is of course our main goal. How large the structural operations will need to be for that is an empirical question. That will be answered in due time when our balance sheet decreases. But we have plenty of time for that.

Q: Why is Finland among the worst hit economies in the euro zone?

A: There are several factors explaining our weak growth performance. As a neighboring country to Russia, the war in Ukraine impacts us more than most other countries in the euro area.

Monetary policy tightening has weakened demand as has inflation. While transmission channels are largely common among the economies, there are differences in the speed of monetary policy transmission. Tighter policy has been transmitted in Finland rapidly, for example because mortgages tend to have variable rates. So, rising interest rates have been more rapidly increasing loan servicing costs for Finnish households.

Other structures of our economy also impact the pace of monetary policy transmission. The Finnish industrial structure is more heavily weighted towards manufacturing and construction, which increases the economy’s interest rate sensitivity. We know that services are less sensitive to interest rates than construction.

Q: How big is the Russia impact?

A: Before the war, Russia's share in our exports was slightly higher than for others in the euro area. Now exports to Russia are at their lowest levels since the Second World War and our companies have withdrawn from Russian markets almost completely. The indirect effects are even larger. For example, we have lost a relatively inexpensive supplier for inputs to our industry. One of our comparative advantages had been the relatively cheap energy and raw material imports for the forest industry from Russia. This comparative advantage is lost permanently or at least very persistently. The increased self-sufficiency in electricity production has helped somewhat, but we still have a deficit in our energy balance, and imported energy has become more expensive. The Russian war has also deepened the deficit in our services trade balance, as Russian tourists are not allowed to come to Finland anymore.

Q: Do you see any signs of a reputational risk from Finland’s geographic proximity to Russia?

A: We are seen for good reasons as an extremely stable country in Europe and sovereign spreads reflect that. The fact that we are now a part of NATO also helps.

Q: What is the way out of the deadlock between unions and the government on labour market reform?

A: Labor market reforms are necessary and the government’s aim to improve incentives to work and to cut public expenditure are understandable. Our public finances have weakened, and the debt ratio is on an upward trajectory. Bringing public finances closer to balance on a long-term basis requires concrete measures that affect both revenue and expenditure. But also structural reforms, such as labor market reforms, that support economic growth are needed. These measures are indeed needed if we want to preserve the Finnish welfare state without compromising too much the level of our public service. Delaying the implementation of these measures would only make it more difficult and more costly. The effect of the unrest on the labor market for the economy is obviously an unambiguously negative. I hope and believe that all parties involved would soon find a way forward. After all, it is in all parties’ interest that Finland has prosperous firms with satisfied workers.