Governor Olli Rehn: Interview with Reuters, 16 October 2020

Governor Olli Rehn
Bank of Finland
Interview with Reuters, by Balazs Koranyi and Francesco Canepa
Published 16 October 2020

The second wave of coronavirus is upon us and we’re seeing an increase in the number of localized restrictions. Is all this still built into the ECB’s projections? How is the economy developing compared to the ECB’s forecasts?

Indeed, the second wave is definitely with us now. But the situation seems to differ between countries. We have learned a lot from the spring, and we can hopefully be more effective now in balancing both public health and economic concerns. The more drastic the possible new lockdown measures, the greater the economic consequences.

As regards the projections, the incoming data have been roughly in line with the baseline scenario of the ECB’s September forecast. However, some recent indicators, especially from the service sector, have been somewhat disappointing, which amplifies the downside risk to the economic recovery.

What we see now in both the global and the euro area economy and even in Finland, is that the hit this year has been more moderate than originally forecast. But the recovery, the rebound is also weaker than expected. So, in a way, the shape of the recovery in my view could be best described as a truncated square root.

The euro area, we will return to the pre pandemic levels of activity sometimes towards the end of 2022.

Do you think the situation has gotten worse enough to warrant action already in October?

We always act when we deem it appropriate on the basis of economic developments in line with our mandate. October is no different.

Given that the recovery is shallower than expected and the downside risks have increased, what’s the policy implication for the ECB?

That will depend on incoming data. In December we’ll have new projections for 2023 as well, so we’ll have to see how the inflation and the growth outlook will evolve. We’re ready to adjust and use all our instruments as appropriate.

ECB board member Fabio Panetta recently said that it’s better to err on the side of doing too much rather than too little. Do you agree with his view?

Inflation risks are on the downside, this is my starting point. It is better to be safe than sorry. Against this backdrop, in my view, ample monetary stimulus remains necessary. There’s a very solid reason for this: large and prolonged downturns tend to have scarring effects for the economy. These effects are caused by lower investment and consumption. That’s one of the lessons of the euro crisis and from the Nordic banking crisis. In the current low growth, low inflation environment, it’s precisely fiscal and monetary policy together that can lift the euro area out of this low inflation, low growth trap. I find it very important that the Next Generation EU Fund is seen as a window of opportunity for enhancing a green and digital transformation.

Do you see a rising risk of deflation?

The inflation outlook is indeed subdued and inflation is currently far away from our aim. However, our policy measures have, at least so far, been effective in tackling the risk of outright deflation. It’s important to continue to be vigilant but for the moment the risk of deflation is more limited than it was in March. Having said that, clearly, we have headline inflation and core inflation that are below our aim and we’ll take that into account in our future decisions.

What did you mean when you recently discussed a “genuinely symmetric” target? And would you agree with your colleague Francois Villeroy de Galhau who said the ECB should tolerate inflation higher than 2% for some time?

One element is analysing how inflation targeting worked in the past. In the early years of its operation, the ECB was aiming at creating credibility in an environment when higher inflation was the main concerns. This led to the ECB successfully capping inflation expectations. In the current environment of chronically low inflation, it’s more important to ensure that inflation expectations are not anchored at too low levels. A necessary but not sufficient condition in underpinning more reasonable inflation expectations is to make sure our inflation target is both defined and understood by the public as symmetric.

Another issue is our reaction function. Researchers at the Bank of Finland concluded there has  clearly been asymmetry in the reaction function of the ECB and in my view, in the current situation where inflation expectations are anchored at too low levels, it’s important that our reaction function is sufficiently forceful and equally effective in reacting to deviations in both directions.

What does this mean in practical terms? What’s a definition that you would consider sufficiently symmetric.

That is something we will need to discuss and subsequently take a collegial decision. In my view, we would need a clear point target and our reaction function should be equally effective in reacting to deviations in both directions. This would also imply that we would accept inflation overshooting the point target or undershooting the point target for a period of time, as long as we’re on path to converging to our medium term, symmetric price stability target.

Is there an element of history in this, as in if the ECB undershoots for a period of them, then it will overshoot for a period?

The U.S. Federal Reserve recently concluded its own review and Chair Jay Powell described the conclusion of its revised monetary policy framework as a flexible form of average inflation targeting. Which, as you point out, takes into account history. While price level targeting as suggested by Ben Bernanke or average inflation targeting is open to criticism from the point of view of communication, in this context is nevertheless worth exploring in depth.

There’s one essential reason for this – and the U.S. and European economies are not that different in this -- and that’s related to employment and slack. The Fed realized that the economy can run longer with low levels of unemployment, which benefits social inclusion and various minorities without inflation getting out of hand or even rising to the target. Something has happened in the labour market and we don’t yet fully know what.

The Phillips curve has by and large flattened if we look at wage inflation and traditional unemployment figures. But if you look at core inflation and the broader definition of unemployment, there’s a certain nonlinear correlation. The non-linearity seems to be such that the economy can stand lower levels of unemployment i.e. higher levels of employment without rapid inflation. If this is the case, from the point of view of economic and social welfare, it makes sense to accept certain period of overshooting while taking into account the history of undershooting.

When you discuss welfare, social inclusion and employment of lower-income brackets of society, that’s a broad interpretation of your mandate. Do you think that’s the way to go?

The ECB’s mandate is defined in the Treaty of the European Union and that is taken as given. The mandate is very clear in the sense that it has both a primary mandate and other essential objectives as long as price stability is not compromised. This means that, on the basis of the EU Treaty, the ECB’s task is to support the other policy objectives of the European Union such as full employment, balanced growth and sustainable development. We should support these objectives as long as price stability is not compromised.

Is there a danger that these objectives conflict with each other or with the ECB’s independence? If you help governments on, say, social justice, can you ever tighten policy without being told you’re going to make social injustice worse? And if you tell governments to spend more, they’re going to ask in return that you keep interest rates low.

That’s why the primary mandate is defined in the Treaty very clearly and that is price stability. That’s in the DNA of central bankers and of the ECB’s Governing Council. In the current context and in the medium-term horizon I do not see that these objectives would be in conflict with each other. But, yes, it is quite possible, and even likely, that at some point there will be a policy trade off. But as I said, and I refer to the Fed’s conclusion in its strategy review, in the current low-growth, low-inflation environment we‘re actually quite far from this type of problems. But, and that’s the second part of your question concerning fiscal dominance, we’re concerned about fiscal dominance and we’ll safeguard central bank independence and the price stability mandate of the ECB. This implies that when we see that inflation is in a robust manner converging towards our price stability mandate in line with the price stability target that we’ll redefine in the context of the strategic review, then we’ll take policy decisions. But I’d underline that I do not see that we should at the current juncture, or in the near term, reduce our monetary policy stimulus. That moment is not around on the corner or not even on the horizon.

Do you think a digital euro is needed and that we’re going to see it soon?

The ECB has taken a big step forward thanks to the work done by Fabio Panetta, Ulrich Bindseil and this high level group on CDBC (Central Bank Digital Currency). We had a conference two years ago in Helsinki organized by the Bank of Finland. One of keynote speakers was Nobel laureate Bengt Holmström who said, only half-jokingly, that it would be good if some non-systemic country like Uruguay or Sweden would first pilot the test of a CDBC. Now we see that there is much more movement also by larger central banks. The ECB has published this report and has moved from being a late comer to being, together with others, on the front row on working and analysing a digital euro or CDBC. We clearly agreed that we don’t yet take any definitive decision on whether to move towards a digital euro or another kind of CDBC. But we’ll first continue the analysis on whether to move into an experimental phase and only then we’ll decide whether this is sufficiently reliable and mature for us to move forward.

Do you have a personal view?

My personal view is that it is very likely that we will see a digital euro sometime in the course of the coming decade in one form or another. But we will first analyse and experiment. And we will also prepare it in very close dialogue with citizens because there are plenty of question marks. And one important element is that it will not replace cash; it will be supplementary to it, which I think is important for citizens.

When you say in one form or another, do you mean that it could also come from the private sector, like a Facebook Libra pegged to the euro?

I didn’t mean that. There is a perimeter of options in my mind and in the report of the working group. We will focus on a retail digital euro and we want to work together with the private sector so that we take into accounts the realities of the payment system in Europe and that we align this with the general European payment strategy, which was just recently adopted.

Do you agree that the ECB could buy more green bonds by ditching the principle of market neutrality in the corporate purchase programme?

There have been important statements about this by President Lagarde and by board member Isabel Schnabel. They go very much in the same direction as my thinking and the practice of the Bank of Finland already today. As you know, in the Eurosystem, we have monetary policy purchase programmes and then our own investment portfolios. In our investment policy we have in the past two years applied sustainability principles in line with the U.N. principles for sustainable investment. Therefore, it’s only logical that I would be supportive of this in the context of the ECB’s purchase programmes.

I think Isabel had a good point in that if there are clear market failures we have to look at ways and means to correct them. Having said that, the central bank alone cannot solve climate change. We’ll have to do our part but in the big picture what is really important is whether the countries of the world unite and agree on measures in order to contain and mitigate climate change. Here the first-best solution would be a global carbon tax. It would require very broad agreement and we don’t see that the U.S. and China would be ready for that. So, we have to work on the basis of a second-best solution which is basically a climate agreement à la Paris and then national or regional policies on how to achieve that. I think the European Union is in the avant-garde in that regard. We are the front-runners with our emission-trading schemes and other measures to combat climate change. The central banks will have to do more and do their part, but the broad picture is that governments together with civil society and businesses are key actors in this context.

How important is it to keep consensus in the Governing Council going forward?

The essence of decision-making in the Eurosystem is that the Governing Council has proven its capacity to make decisions in difficult times as has been the case also during the Covid-19 crisis. On the Governing Council, we always work based on the common mandate of the ECB and thus we share the same foundation and framework. Having said that, it is natural that sometimes there are different opinions and those views enrich the debate and do not cause disunity. But, as it has also been stated by Christine Lagarde, once decisions have been made we need to defend our common position in a united manner, not least because we want to maximise the effect of our policy, and communication is an essential part of modern central banking.