Member of the Board Tuomas Välimäki
European Monetary Policy in the Current Global Economy
Keynote speech, Nordic Banking Forum
Helsinki, 11 October 2023
European Monetary Policy in the Current Global Economy
Let me start by thanking the organizers for the invitation. It is a great pleasure to address the Nordic Banking Forum, which brings together bank executives from the Nordic and Baltic countries, our home region.
As you know, the central banks and supervisors in this region have collaborated closely and frequently for decades. We know each other well. In addition to closely connected financial systems, we share many key values that guide our everyday work.
In that spirit, and before I start on today’s subject, I would like to draw your attention to the Nordic-Baltic regional report on financial flows analysis, AML/CFT supervision, and financial stability that was published by the International Monetary Fund last month1. The Nordic-Baltic authorities commissioned the IMF to look at financial integrity risks from the regional perspective some time ago and the work is now completed. I hope the report can contribute to your work and maybe also to your discussions in this forum.
Let me now share my views on Euro Area Monetary Policy in the Current Global Economy.
Whether in the realms of banking or central banking, it is evident that the current operating environment poses ongoing challenges, both on a global and regional scale. The recovery from the consequences of the pandemic and of Russia’s illegal war in Ukraine has proved slow and uneven. Growth in the global economy is expected also to continue at a slower pace than we have experienced in recent decades. There are both cyclical and structural reasons for this.
Similar to the pandemic and the war, many of the economic challenges our countries face today have a significant global component. First and foremost, high inflation is a global phenomenon. As a result, tighter monetary policies to bring inflation under control has restricted demand worldwide.
Decisions by central banks to raise interest rates have been essential for anchoring inflation expectations, preventing the wage-price spirals and eventually for strengthening households’ purchasing power. Unfortunately, the extended period with high inflation has, once again, affected especially those that must use a large share of their income on everyday necessities, food and energy in particular.
In addition to restrictive monetary policies, the demand-boosting effect of fiscal policies has grown smaller. After the pandemic, the needs for financial support have eased and the sharp rise in public debt levels and interest rates has added to loan servicing costs. In an environment of high inflation, it is of particular importance that monetary and fiscal policies do not have conflicting impact on demand, otherwise central banks would have to employ even stronger policy stance.
Regardless of your perspective, bringing inflation down sooner rather than later is the key priority for economic policy makers everywhere. There is a wide consensus on this matter.
Indeed, inflation is currently receding on a global scale; however, we, central bankers, find its deceleration to be painfully slow. Projections indicate that in euro area as well as in many other countries around the world, the central banks' targets for price stability are unlikely to be achieved until 2025.
While GDP growth in the United States has recently exceeded projections thanks to robust consumer spending, China's economic growth has unexpectedly weakened. Geopolitical tensions and fragmentation have intensified, creating frictions and disruptions in trade, heightened volatility in commodity prices, and a deceleration of the vital green transition. Additionally, the prevalence of extreme weather events has surged, resulting in increased human suffering and additional economic strain.
Nevertheless, it is worth noting that not all challenges this year have been experienced on a global scale. The threats to financial stability in the spring served as a valuable reminder of the importance of being prepared for unforeseen events. Fortunately, immediate action by authorities in the United States and Switzerland swiftly calmed the turbulence. Similar disruptions were avoided in the euro area, and also in the Nordic-Baltic region, largely thanks to the resilience of our financial and banking systems.
This said, it cannot be ruled out that the rapid rise in interest rates still carries the potential to trigger disruptions within the financial system. As central banks, we stand ready to take targeted actions in response to such occurrences. Nevertheless, our intention to keep monetary policy stance restrictive as long as needed to safeguard our price stability objective remains steadfast, and we will not compromise on this.
Therefore, maintaining robust capital and liquidity buffers of banks is crucial going forward. Notably, the swift transmission of higher interest rates to bank lending rates, far outpacing the adjustment in retail deposit rates, has yielded substantial windfall gains for many banks in the Nordic-Baltic region. Yet, this kind of partial pass-through of monetary policy cannot be considered a sustainable long-term norm. In light of the considerable uncertainties that confront us all, a forward-looking perspective throughout the entire business cycle becomes imperative. This should remain at the forefront of discussions in bank boardrooms as they consider profit allocation in the coming year.
With inflationary pressures in the euro area proving to be stronger and more persistent than previously projected, we in the ECB Governing Council have raised our key interest rates by a total of 450 basis points since July last year. The policy rate we use to steer market rates – the deposit facility rate – stands now at 4.00%, after the 25 basis points hike in our September meeting.
While the ECB’s steering rate has been higher in the past2, the current series of interest rate hikes made in ten successive monetary policy meetings has been exceptionally rapid and forceful. Our interest rate adjustments have been driven by a firm commitment to bring inflation back to our target in a determined manner in accordance with our price stability mandate.
Euro area inflation is slowing but is still expected to remain too high for too long. The latest ECB staff projections show that by 2025, inflation in the euro area will have remained above the ECB’s 2% medium-term target for more than four years.
Ladies and gentlemen,
Based on our current assessment, the Governing Council considers that the key ECB interest rates have now reached levels that, if maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target.
In fact, the ECB’s September staff projections indicate that euro area inflation slows close to the target by the end of the projection horizon without any additional interest rate hikes. This can be seen as encouraging, as these are the first staff projections that indicate so in this tightening cycle.
But considering the risks surrounding the inflation path, this does not necessarily mean there will be no more hikes. Because inflation is staying above the target for this long, further delay in achieving the target cannot easily be justified. When we say that we aim at our 2% inflation target over the medium term, it is worth noting that the clock’s not only ticking, but it started doing so already some time ago. In any event, the ECB’s future decisions will ensure that the policy rates are set at sufficiently restrictive levels for as long as necessary.
The ECB will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. Interest rate decisions will be based particularly on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.
As those of you who operate in the euro area have seen the developments in your banks’ balance sheets, it is evident that the financing conditions have tightened further and the ECB's interest rate hikes continue to be forcefully transmitted to the euro area economy. This is having a dampening effect on overall aggregate demand.
With domestic demand softening and the demand for exports losing momentum, growth in the euro area economy came to a halt in the first six months of this year and is expected to remain sluggish in the second half as well.
However, what we see is not a recession but a standstill. And it is not only the ECB projections which indicate so but also the projections of the other major forecasters. Strong labor markets play a central role in this baseline scenario. Although growth in employment is slowing, it is expected to remain positive. Unemployment is projected to grow only slightly from its record low of 6.4%.
These estimates anticipate a ‘soft landing’ for the euro area economy. As longer-term inflation expectations have stayed anchored in line with the ECB’s target, wage growth is projected to moderate. The slowdown in inflation is nevertheless pushing up real wages, and this is expected to boost private consumption – which is important for growth – next year in particular. It should be noted, however, that there are significant downside and upside risks to the outlook for the economy and inflation.
When monetary policy is tightened in a determined manner to bring down high inflation, it weakens GDP growth temporarily. It is therefore important that central banks openly explain the objectives and reasoning behind their decisions. This kind of openness is one of the shared values of Nordic-Baltic central banks I mentioned earlier.
The primary objective of the ECB is to maintain price stability, which means an inflation rate of 2% over the medium term. To ensure price stability and the credibility of monetary policy, it is important that achievement of this inflation target is not unduly delayed, that inflation expectations do not become de-anchored, and consequently a price-wage spiral will be avoided.
We stand ready to adjust all our instruments within our mandate to ensure that inflation returns to our target and to preserve the smooth functioning of monetary policy transmission.
I wish you a fruitful forum and journey through the interesting landscapes you have identified for the forum sessions.
Thank you for your attention.
2 Before 2015, short-term market rates were mainly steered with the rate applied in the Main Refinancing Operations.