Board Member Tuomas Välimäki: Views on the Finnish and euro area economies and the ECB monetary policy, London 26.1.2024
Member of the Board Tuomas Välimäki
Views on the Finnish and euro area economies and the ECB monetary policy
The European Economics and Financial Centre
Distinguished Speakers Seminar
London, 26.1.2024
Presentation (pdf)
Views on the Finnish and euro area economies and the ECB monetary policy
Dear Colleagues and Friends,
I am grateful for this opportunity to share my thoughts with you today on the euro area economy and the Finnish economy. I have just arrived from Frankfurt where we, the ECB’s Governing Council, decided yesterday to maintain our monetary policy stance unchanged. As at least some of you have read about our decisions and maybe even watched the press conference by President Lagarde, I will not dig deep into the details of the decisions, but rather provide you with an overview of the factors affecting our decision-making. I will also lay out my own thinking on the current monetary policy situation in the euro area.
Policy rate increases have been rapid and strong [Chart 2]
We have executed a historically strong hiking cycle during which the ECB policy rates have been raised by 4.5 percentage points. And this has taken place within a short time frame: only 14 months between the first rate hike in July 2022 and reaching the current rate of 4 percent in September 2023. So, yesterday we decided to continue with the ECB deposit rate, our key policy rate at 4 percent. The two previous hiking cycles were only half the size of this one. In the cycle that occurred prior to the global financial crisis, it took almost three years from trough to peak.
Why being so forceful this time? Basically, there are two reasons for this. First, inflation increased abruptly to levels unforeseen in the euro area. The 10.6% peak we saw in October 2022 was 2.5 times higher than the previous record inflation in 2008.
Second, we started hiking from extremely low levels. In summer 2022, our main policy rate was still negative, at -0.5%, i.e. we were at the effective lower bound. We needed to be aggressive, not only to bring rates up to the positive side but also to take them into restrictive territory. This was done with several consecutive half or three-quarter percentage point hikes.
Besides the intensity, there are also some other differences in comparison to previous cycles. This time the rate rises have been synchronized across most developed economies. Moreover, in addition to short rates, our policy has significantly raised long-term rates. The scaling down of the ECB’s outright purchases has certainly contributed to developments at the longer end of the yield curve.
Let’s look now at the effectiveness of our policy measures, concentrating particularly on two topics: whether the policy is effective in bringing inflation back to the ECB’s goal, and whether the euro area and Finnish economies can navigate through this shock without a hard landing, i.e. without significant slowdown in economic activity and employment.
Core inflation is slowing down gradually [Chart 3]
Inflation in the euro area has dropped from its peak seen at the end of 2022 to 2.9% in December 2023. This is the result of falling energy prices and our decisive monetary policy measures, which dampened aggregate demand and, more importantly, stabilized inflation expectations. Core inflation is also slowing down and gradually approaching our target. Our policy has evidently been effective in dampening inflationary pressures and anchoring inflation expectations. We are on the right track and our monetary policy is working.
This is also reflected in the inflation forecasts produced by international institutions. The ECB’s December projection foresees inflation slowing down further and reaching our target in 2025. There is some variability between different forecasters over the exact month by month trajectory, partly reflecting different energy price assumptions, but the big picture is similar. Inflation is moving towards our 2% medium-term target but from now on relatively slowly. We still need to finish the last mile.
Inflation expectations well anchored [Chart 4]
Currently, both the headline inflation rate and the most common measure of core inflation, i.e. inflation excluding energy and food prices, are still too high. Core inflation now stands at 3.4% and is decelerating more gradually, partly due to the rigidities in service sector inflation. Services’ prices continue to increase faster than we can accept, and we need to be more confident that inflation will reach its target before adjusting our policy stance. Thus, restrictive monetary policy is still called for.
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 costly. We need to avoid declaring victory over inflation prematurely and we need to have enough evidence of healthy core inflation dynamics before we can ease our policy stance.
Inflation dynamics are currently changing. The fading effects of energy price increases and the dissipation of supply disruptions have brought inflation down from record high levels. Looking ahead, services inflation is expected to remain the main driving force for inflation, and it will be strongly affected by how wages develop.
Indeed, key factors affecting future inflation include wage developments and how well inflation expectations remain anchored. Euro area inflation expectations were somewhat volatile in 2022 and 2023 but they have recently stabilized thanks to our policy measures. I believe that our decisive policy tightening has facilitated public trust in our determination to bring inflation to our target. While I have been upbeat over the stabilization of inflation expectations, I believe, we need to be more cautious on wage formation. We simply need more evidence of the stabilization in wage developments. Wage formation plays a key part in our assessment of 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.
Wage inflation still brisk [Chart 5]
By historical standards, wages have increased rather fast for quite some time. The call for compensation by employees is understandable in view of the ex post impact of high inflation on real wages. But the compensation can be only partial, as most of the contribution to high inflation came from energy prices, which from the euro area perspective was an adverse terms of trade shock. Going forward, the assumption must be that wage increases beyond our inflation target and productivity gains would eat competitiveness and result in further inflationary pressures. Having said this, recent wage indicators provide preliminary evidence according to which wage inflation may have reached its peak.
The labour market has so far been remarkably resilient in the current slowdown. The euro area unemployment rate is at a historical low and employment has increased steadily. This supports the view that there will be just a gradual slowdown of wage inflation over the coming quarters. The ECB’s December projection foresees a dampening of wage inflation from last year’s 5.3% to 4.6% this year and 3.8% next year. This seems to be a valid assessment, but we need to gather more evidence from the data.
Euro area’s economic growth expected to remain subdued in near term [Chart 6]
Let me now turn to the growth outlook. The effectiveness of our policy measures will also be evident from this perspective. Restrictive monetary policies are taking effect globally. Indeed, euro area growth practically stalled last year and is expected to remain subdued this year. The ECB’s macroeconomic growth projection for this year is 0.8%, though some other forecasters are somewhat more pessimistic.
However, according to the baseline projection, recovery should start later this year. Wage developments, coupled with moderating inflation, will increase households’ real incomes, which will be helpful in boosting economic growth. Exports have not been strong lately, but we are expecting a rebound from net exports later this year. Also, the financial markets are not factoring in any further monetary policy tightening. In fact, quite the opposite. This could also support the gradual recovery of euro area economic growth.
Based on current evidence, the baseline scenario for the euro area is still a soft landing. By this, I mean a gradual slowdown in economic growth and inflation, avoiding an abrupt shock, avoiding recession, and avoiding a significant increase in unemployment. A number of international institutions, such as the IMF and the European Commission, share this assessment.
However, significant uncertainties around the inflation and growth outlook are lurking beneath the surface. First of all, energy prices are volatile and could create volatility in inflation developments. Upside risks to inflation include heightened geopolitical tensions, which could raise energy prices or freight costs in the near term and lead to new disturbances in the value chain. Inflation could also turn out higher than anticipated if inflation expectations were to drift away from the target, or if wages or profit margins were to increase by more than expected.
Downside risks to inflation include an unexpected deterioration in the economic outlook, which would then reduce inflation more quickly. The risks to economic growth are indeed currently tilted to the downside. Growth could be lower than anticipated particularly if the impact of monetary policy turns out to be stronger than expected.
Finland’s economy is in recession and will recover slowly [Chart 7]
Let me now turn to my home country, Finlad. Similar developments to those in the euro area are also affecting us. The Bank of Finland’s most recent forecast for the Finnish economy points to a somewhat weaker outlook than I described for the euro area. Economic activity was weak towards the end of 2023, and leading indicators do not yet show a turn for the better. The economy was in recession in the latter part of 2023 and growth is expected to be negative also in 2024, and the recovery to be slow. The external operating environment of the Finnish economy is difficult: growth in our export markets has slowed and the geopolitical situation adds challenges for Finland's foreign trade.
However, household income will gradually strengthen as inflation slows rapidly and wages rise. Growth in export markets is also expected to gradually pick up. In addition, the pass-through of rate hikes has been fast in Finland, and, correspondingly, the impact of a reversal of the rate cycle, when it materializes, will also be rapid.
All these factors will support the recovery of economic growth in Finland. In 2025 and 2026, the economy will grow again, but growth is expected to remain fairly moderate.
There are many reasons for the somewhat downbeat outlook.
Replacing the lost Russian markets has taken somewhat longer than expected. In addition to losing this neighbouring export market, we also lost a supplier of relatively inexpensive inputs to our industry.
One of Finland’s comparative advantages was the relatively cheap energy and raw material imports from Russia to, for example, the forest industry. This advantage is now lost, perhaps permanently. Finland’s 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. Furthermore, the reduction in tourism from Russia and Asia is curbing Finland’s services exports.
Despite this, I think we should be careful not to exaggerate the Russian impact on our economic outlook. More importantly, intermediate goods and capital goods, which are sensitive to changes in demand and interest rates, make up a large part of Finnish exports. Also, construction and manufacturing play a larger role in the Finnish economy than in, for example, many countries in southern Europe, where the services sector is more important. And as you know, construction is much more sensitive to changes in monetary policy than services are. Finally, bank lending practices also differ between euro area countries, and this can contribute to the slightly faster transmission of monetary policy to the Finnish economy than in many other euro area countries.
Monetary policy pass-through to housing loans works fast in Finland [Chart 8]
Let me say a few more words about bank lending, which is one of the key channels for monetary policy transmission. In Finland, practically all housing loans are floating rate mortgages, whereas in the euro area on average, most mortgages come with fixed rates. A recently published Bank of Finland analysis1 shows that Finnish economy is more sensitive to monetary policy due to its large proportion of floating rate mortgages.
This chart shows that in Finland, the average interest rate on new housing loans has increased in tandem with expected policy rate changes throughout this interest rate cycle. The increase from the lowest point to last October was 3.7 percentage points. In the euro area on average, the increase was 2.7 percentages points. Although the rate on new housing loans has increased significantly more in Finland than in other euro area countries, the increase in the average rate is actually much stronger when it comes to the whole outstanding stock of loans. This is due to the short interest rate setting intervals applied in Finland. Whereas the average interest rate on the outstanding stock of housing loans in the whole euro area increased by 0.8 percentage points up to last November, in Finland the upsurge was 3.2 percentage points, i.e. four times greater.
Based on these figures, it seems clear that the monetary policy pass-through to Finnish households has been much stronger than in the rest of the euro area on average. However, it will be stronger also when policy rates go down. In the 2010s, the average interest rate on outstanding housing loans did not decrease as quickly or to such a low level in the euro area as it did in Finland. Hence, for a long time Finnish households enjoyed considerably lower mortgage rates than households in the euro area on average. Indeed, the difference was close to 1 percentage point for ten years before the rate rises started.
It is, perhaps, interesting to speculate, what if fixed rate housing loans had been as common in Finland as in the other euro area jurisdictions? The analysis presented in the Bank of Finland Bulletin highlights that the loan servicing costs of mortgage-holding households would, on average, have increased less and more slowly than those based on adjustable rates. This certainly would have supported household consumption. However, it is worth mentioning that only around one third of all households in Finland have outstanding housing loans.
Consumption by those households that do not have housing loans is naturally not directly affected by the prevalence of variable rate mortgages. Moreover, a majority of the households that have a mortgage are high-income households. These households tend to have a financial margin that they can use to cope with increased loan servicing costs and to smooth consumption over time. This dampens the speed of transmission to Finnish households.
Finally, let me emphasize that potential differences in the pass-through of monetary policy via the bank lending channel to household consumption are likely to be symmetrical. It is evident that much of the dampening effect of monetary tightening still is in the pipeline. Nevertheless, when it comes to the impact of rate hikes on household borrowing, Finnish households may in fact soon be past the worst of it. The average interest rate on new mortgages in Finland started to decrease already in November, and at current money market rates the resetting of interest rates on the existing stock of loans will soon start to decrease the average lending rate.
Loan stocks now and in the 2005 hiking cycle [Chart 9]
I shall finish up now with a slide that compares the impact of the current hiking cycle on euro area loan stocks with the impacts of the two previous hiking cycles we have experienced.
The strong transmission of our recent policy rate hikes can be illustrated by the development of loan stocks and the demand for new loans, both of which have weakened considerably. On this slide, we compare the current euro area tightening cycle to the cycle that began in 2005 as well as to the current cycle in the United States.
The demand for new loans in the euro area has now reacted much more strongly to our policy tightening than previously. This also reflects the different drivers of high inflation. In this hiking cycle, negative supply shocks have been the main driver behind high inflation strongly affecting our economy, whereas in the previous cycles, increases in inflation were mainly demand driven.
While comparisons of different hiking cycles should be interpreted with caution, the dampening of loan demand is a clear sign that our restrictive monetary policy has had a significant impact in stabilizing inflation. At the same time, resilient economies, robust banking sectors, strong labour markets and manageable sovereign bond spreads have alleviated the effects of negative supply shocks and higher interest rates as well as increased the probability of a soft landing in this hiking cycle.
To conclude, I have set out here my thoughts on the current euro area economic outlook and the impact of our monetary policy. Journalists have asked me about the timing of the awaited turning point in our interest rate cycle. Unfortunately, I cannot give an exact date. The economic outlook and inflation dynamics are currently subject to significant uncertainties.
The best way to address this uncertainty is to base monetary policy decisions on the latest information and to move forward in a data-dependent approach in our decision making in the forthcoming meetings.
The ECB Governing Council has clearly stated that there are three specific criteria that it will base its interest rate decisions on: an assessment of the inflation outlook considering the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. I consider that our policy rate is currently at a level at which it has made and continues to make a substantial contribution to our price stability goal. The future decisions by the Governing Council will ensure that policy rates will be set at sufficiently restrictive levels for as long as necessary.
So far, our monetary policy has been effective in bringing inflation down towards our medium-term target of 2 percent. It has also anchored long-term inflation expectations in line with our inflation target. Monetary policy is clearly in restrictive territory, and we are on track to meet our price stability goal. Instead of guessing the moment when monetary restriction can be relaxed, it is better to be safe than sorry and just follow the data dependent approach.
[Chart 10] Thank you for your attention, and I am now open for questions.