Governor Olli Rehn
Bank of Finland
Interview with Reuters, by Balazs Koranyi and Anne Kauranen
Published 28 September 2022

Q: How do you assess economic developments since your last policy meeting?

A: I think it's better to look at how trends have evolved since the spring, over the summer and in the more recent period. In May and June, the discussion primarily focused on inflation. Then, over the summer months, the risk of recession entered the picture. In both the euro area and Finland, we have seen both an excessively high rate of inflation -- mainly due to the energy crisis -- and an increasing risk of a recession.

Second quarter growth was somewhat better than projected but on the basis of consumer sentiment indicators and other incoming data, the risk of a recession has increased. To that, we need to add the pervasive uncertainty due to Russia’s brutal war in Ukraine, and the subsequent energy crisis.

Much depends on Europe's ability to stay united and act with determination to resolve or mitigate the ongoing energy crisis and to continue to support Ukraine.

Q: What is the short-term mitigation?

A: I refer here to the ongoing discussion of the European Union about the electricity market. A key issue is that the electricity market is affected by the benchmark price of natural gas. The price of gas has multiplied because of the excessive dependence of many countries on Russian fossil energy, especially gas. Some power markets use this gas as a reference price, and this is a serious concern for our citizens.

Q: What is the solution you're hoping for?

A: There are different ways of delinking the electricity market from gas. You can either have a price cap on gas, which would affect the whole electricity market, or you can have, as the Commission proposed, a price cap on electricity produced via other forms of energy.

Q: What will be the effect of possible power cuts in Finland over the winter.

A: Power cuts are possible, but they are not self-evident. I believe that we have a significant potential for saving energy and electricity in Finland. It’s important to remember that we have to give up something completely different than Ukrainians. Our suffering is very, very limited compared to what the Ukrainians are suffering because of Russia’s illegal and brutal aggression and war. I certainly hope that the Commission proposal will lead to a concrete solution that will alleviate the dire situation in Europe.

Q: What is your projected profile of inflation?

A: It will depend very much on developments of the energy crisis. Our forecasts assume that we will see somewhat slower but still excessively high inflation next year.

We are taking policy decisions based on the best available incoming data on the economic and inflation outlook. And we are taking decisions meeting by meeting.

Q: How concerned are you about the continued increase of core inflation?

A: That’s really the crux of the matter.

For euro zone inflation, there is one driver above others and one anchor more important than others.

The driver is obviously energy. The anchor is relatively moderate wage inflation so far.

If you compare the US and Europe, we are in a different place. The euro zone faces a challenge because of its dependence on imported fossil energy. The US on the other hand is running a red-hot labour market. Europe also has some labour shortages but not to the same extent as the U.S.

A very important indicator is the vacancies to unemployed ratio. In the U.S., there are two job vacancies for every registered unemployed. In the euro zone, there is one vacancy for two unemployed persons.

Negotiated wage growth in the U.S. has been between 5% and 6%. In the euro zone we have seen an increase from 2-2.5% to 3-3.5%.

In Europe, we have seen some increase in short term inflation expectations, and we need to be concerned about that. On the other hand, longer term expectations are still by and large anchored.

Q: Inflation has also broadened. Does that give you cause for concern?

A: It does and that's a further reason why we decided on the rate hikes. Expectations play a role. Recent research seems to indicate that if inflation is excessively high for a longer period of time, people become more backward looking in their inflation expectations. That leads to inflation expectations becoming entrenched.

Today there's a stronger case for frontloading rate hikes compared to gradualism, mainly to ensure that inflation expectations do not become entrenched.

If inflation becomes more demand driven, then it becomes more difficult to contain and you have to pay a higher price in the medium term.

Until early this year, I was in favour of gradualism but for now, there is a stronger case for frontloading and determined action.

Q: Is frontloading still appropriate in October?

A: We take decisions meeting by meeting, based on the best available economic data. But in my view, it's worth being consistent. In the current inflation environment, frontloading is justified.

There is a case for taking a decision on another significant rate hike, be it 75 or 50 basis points or something else.

Q: President Lagarde said the ECB will raise rates to the neutral level, then consider if further steps are needed. When should we get to the neutral?

A: The neutral rate is a fluctuating concept and not empirically straightforward. When we talk about the neutral rate, we talk of proxies or ranges. Having said that, it is still a meaningful concept. I share the view of President Lagarde and in my view, we are heading towards the range of the neutral rate by Christmas. Once we get there, we’ll see if there’s a case to move into restrictive territory. Let's cross that bridge once we get there. I'm agnostic in that regard. If we deem that the inflation outlook calls for a move towards restrictive territory, so be it.

Q: How does the euro’s weakness affect your calculus?

A: We don't regard the exchange rate as a policy target. But of course, it affects the economy and inflation, so it does play an indirect role in our broader equation. The import bill of the euro zone has become huge, and those imports are largely denominated by dollars.

Changes in the EU’s import bills are quite illustrative. In 2019, the import bill of fossil energy, mostly from Russia, was a bit above 300 billion euros. Taken into account what has already been paid in the first eight months and prospect for the rest of the year, this year will be around 900 billion euros. The difference, 600 billion euros, is about two and a half times the GDP of Finland. It’s an extra tax on European consumers worth about 4% to 5% of GDP. 

Q: Is it time to discuss reducing or ending APP reinvestments?

A: We have not yet discussed a reduction of the balance sheet of the ECB. We will do that in an orderly manner. Everybody knows that at some point this will be part of the normalization process.

Q: Should you get done with rate hikes before reducing your balance sheet?

A: I would prefer not to make unnecessary linkages at this stage, sequencing has not always been helpful.

Q: Should you limit commercial banks’ return on excess reserves and TLTROs?

A: It’s meaningful to recall the motivation of these refinancings operations. They were designed during the COVID 19 pandemic to ensure that the banking system will lend to households and corporates on rather favourable basis. We will need to analyse this in light of our monetary policy stance and see whether or not these favourable terms are still justified.

Q: Are they justified?

A: In the current and future context, one can say that these terms are quite favourable for the banks and I would be in favour of looking into this matter. We will analyse this and conclude our analysis on the basis of the best effect from the point of view of our monetary policy stance.

Q: How about reverse tiering?

A: I don't want to take any stand on technical solutions at this stage.