Governor Olli Rehn: Interview in Financial Times, 6 February 2025

Governor Olli Rehn
Interview in Financial Times, by Olaf Storbeck
Published on 6 February 2025
an edited transcript of the interview

What’s your view on a potential trade war between Europe and the U.S.?

Rehn: In the current context where there is an ongoing brutal war in in Europe, and weak growth, the last thing we need ist a new trade war — especially between allies.

But how well is Europe prepared? My understanding is that the European Commission, together with the member states, have been preparing for the possibility of President Trump setting high tariffs on Europe.

The European Union is a single market, it's a large market of 450 million consumers, which is interesting to any trading partner. We also have a common trade policy. The European Commission has strong prerogatives in trade policy, which is a safeguard for European unity. In other words, when it takes an initiative in trade, that initiative has fair chances of being realized and it’s not easy for any one member state to block it.

We have 46 bilateral or regional trade agreements, which covers almost half of the EU's external trade. In addition to that, the European Commission has recently opened up new trade relations, such as for example Mercosur, and upgraded trade relations with Mexico. It's important to continue to expand our trade relations, not least to the global South.

When facing announcements of high tariffs by the Trump administration, it is essential that we prepare policy measures to reinforce Europe's negotiating position.

In the grand scheme of things, the reaction from Europe to geopolitical uncertainties should be more Europe and in particular a more united and integrated Europe.

Would you say that Europe's negotiating position in that regard is better than many believe?

Rehn: We have our challenges and we need to make reforms, cut red tape and reinforce innovation. But at the same time, we have the largest single market in the world and a common trade policy. We should have more self-confidence.

Europe has intellectual expertise and experience leading trade group negotiations. Is this potentially an advantage if it will have to negotiate for itself?

Rehn: That’s a very important point. Over decades, the EU and Commission have accumulated a strong competence in trade negotiations, and our trade policy is predictable. This makes the EU an interesting partner for many, many other countries, and we should certainly capitalise on this.

There are no winners in trade wars, but we need to have sufficient self-confidence and ensure European unity so that we can succeed in this difficult environment.

What response would you recommend if Canada-like tariffs would also be imposed on European goods?

Rehn: On this, I agree with the leaders of the European Commission that it's better not to go into details at this point. It's better to prepare policy measures, consult the member states and only make it specific if Europe is actually targeted. But I think it's clear that we will need to take action.

So the EU needs to retaliate at some point?

Rehn: If we are going to be targeted by the US, we need to take proportionate policy measures.

In November, President Lagarde suggested an alternative approach: do not retaliate immediately but try to find a constructive solution fast. If this initial stage doesn't work and you end up with tariffs, should the EU then still continue to negotiate? Or should it draw a line in the sand and retaliate?

Rehn: If you ask most economists, they would say that it would be better not to retaliate. But this is not only [about] economics. This is mostly politics.

I would add two points. One is that the first goal must be a negotiated solution to avoid any trade war. Second, as we discussed before, the EU has means to reinforce its negotiating position, and that calls for expanding trade relations, not least to the global South, and also preparing policy measures in case they are needed.

One big question is: how rational is the U.S. administration on this?

That's the issue. There seems to be a different kind of rationality in Washington these days than what we are used to in international relations.

Optimists could say that these threats are just a negotiation tool to get outcomes that  the US administration wants. Could they just be a very credibly applied negotiation tool?

Rehn: That remains to be seen. But this time, game theory or other economic theories like the rational actor model of political science might not be the analytical framework to use. If you look at what President Trump has himself stated, he says that he is a “tariff man” and it seems to be a very ideological issue for him and his administration.

Which would be pretty bad for the rest of the world.

Rehn: It's just not good news for the rest of the world, nor for the US, because we've already seen that when these tariffs against Canada and Mexico were announced, the dollar surged, which does not help to solve the trade deficit of the US if that's the objective. Also, we can assume that tariffs will hit most American consumers and will have an inflationary effect on the US economy.

For the rest of the world, like for the Euro area, it is more of an empirical question how much they will affect growth and inflation. Concerning inflation, they affect both exchange rates and growth—and it may be that these effects cancel each other out. We will only have a sense from the data, if and when tariffs will be enforced.

In monetary policy, we can only lean on decisions taken and economic impact observed. Thus, we will continue our close monitoring of protectionist measures.

In the short to medium term, our outlook is dualistic. Disinflation is on track but the growth outlook has weakened and remains relatively weak. The direction of monetary policy is clear, but the speed and scale of rate cuts will depend on incoming data and our comprehensive assessment of economic, financial and geopolitical factors.

If current forecasts and assessment came true, do you think the ECB should swiftly go to neutral? If there’s another cut in early March, the consensus is we won’t be at neutral still. Is this consensus justified? And secondly, some argue that if the ECB cuts in March it should wait in April and only take the next step at the next meeting after that. Can you give us any idea of your own view?

Rehn: We have currently a pervasive uncertainty over the European economy because of geopolitical conflicts and trade protectionism. This justifies moving forward on the basis of a meeting-by-meeting approach and continuing to be data dependent.

There's one important point I want to make, which is that sometimes people perceive data dependency as backward looking. I don't see it at all like that. In my view, data dependency is forward looking. Our inflation target, which is symmetrical at 2%, is defined over the medium term, so by definition it must be forward looking.

The data we analyse comes in different shapes. You have hard, historical data. Then you have forward-looking data. And as president Lagarde said, we also look out of the window at what is happening out there in the world.

We make a comprehensive assessment where we base our decisions on data, but we also use judgement. Making monetary policy decisions is as much an art as it is a science.

And for me, taking decisions at each meeting on the basis of incoming data and comprehensive analysis is particularly justified as we have such a thick, pervasive cloud of uncertainty, especially geopolitical uncertainty.

 Having said that, the direction of travel is clearer for the reasons I mentioned: disinflation is on track; the growth outlook is weak, even though we are forecasting a slow recovery over the course of this year; and we are also still restrictive.

Do you agree that all those arguments speak in favour of not waiting unnecessarily with further cuts?

Rehn: I think it's important to maintain our freedom of action. It relates to data dependency, in a sense that if the economic outlook gets worse, especially concerning growth, then we would have more room for further easing. If the economic outlook is worse because of sticky inflation, then we could have less reason for easing.

So in my view, in this current context of prevalent, pervasive uncertainty, data dependency is particularly justified as long as it is forward looking and based on a comprehensive analysis

The second point is about the restrictive nature of monetary policy, which relates to the question of the natural rate of interest or r*. For the sake of simplicity, let’s talk about the neutral rate, which for me means the natural rate r* plus targeted inflation. Based on our research at the ECB and BOF, I would judge that the lower end of the neutral rate today is approximately at 2% level or slightly below it.

In my view, the natural/neutral rate is an indispensable conceptual and analytical framework for thinking about monetary policy—but it is not a viable, concrete policymaking tool.

On February 7, the ECB will publish a blog post on its research about the calculation of r*. Even after that, by the way, we will have uncertainty about the calculation of r*. We've done our calculus [at the Bank of Finland]. We have a little bit different methodology, which is more forward-looking than the standard benchmark model. Our current estimates of the lower end of the neutral rate are at approximately 2 % or slightly below. But all of this has significant uncertainties.

More generally, R* is unobservable, i.e. it has to be derived with a model. That means is not a very useful concrete tool of policy making in the short term—and you have to think about monetary policy in the short term. We have significant uncertainties in calculating the neutral rate and thus we simply don't know where it is. It's better to have a more operational concrete policy yardstick. I refer to [the ECB’s] reaction function. We look at three factors in particular: inflation dynamics, underlying inflation and the strength of transmission of monetary policy. This is a more viable method of policy work.

We should not constrain our freedom of action because of a theoretical concept, which is nice to talk about when you have a pint in the pub, but it's not suitable as a concrete benchmark for monetary policy.

That’s not to say I don’t care about r*. I'm actually fascinated by the discussion and always have been. But the more one studies it, the more one realizes the uncertainties.

And then from your view, if r* 2 per cent or maybe a bit below, is it still higher than before the pandemic, or is it more or less the same level as pre-pandemic?

Rehn: We saw some discussion during the pandemic about the neutral rate being on the rise. But my reading is that it has not substantially deviated from the pre-pandemic path.

Most of the analysis and data I've seen over the past couple of years suggests that.

What's your view on the risk of undershooting the ECB’s 2.0% inflation target?

Rehn: I'm quite confident that we are stabilising towards our 2% target over the medium term. I would see risks to inflation broadly balanced. It's important to be mindful of the possibility of undershooting, but inflation expectations remain well anchored and headline and core inflation are slowly converging to our target.

For now, inflation expectations are well anchored and we see that several indicators are showing that we are converging to our 2% target. So I would not consider undershooting as the central scenario.

What does all this mean for the approach that policymakers should take from your point of view? One can make two conflicting arguments. One is that central banks should keep their powder dry and wait until they really know what's going to happen. Alternatively, one could also say that given how slow growth is in Europe, they ought to stimulate the economy with the aim of gaining speed before running into a headwind again. Do you have any views on that?

Rehn: In retrospect, we can always conclude that the monetary policy was wrong because we then have full information in the past. We don't have full information now of the present or the future.

So I think in reflecting on the current situation, it's important to note that markets have largely priced in prospective rate cuts. This will stimulate Eurozone countries, which is certainly welcome 

What you are basically saying that we should have stronger forward guidance. But in my view, forward guidance works best when you are fighting deflation. But we are in a very different environment for now, referring to pervasive uncertainty, it justifies decision making at each meeting based on the fresh and relevant data which is forward looking. It's an argument to act consistently and gradually.

In my view, you can combine directional guidance, which is different from forward guidance, and a meeting-by-meeting approach, and the linking factor between the two is forward-looking data dependence.

Directional guidance becomes interesting. Should the ECB ditch directional guidance once it thinks it is at the neutral rate, or not?

Rehn: Let’s cross that bridge when we get there. We are still in the restrictive territory. I think it's important that we maintain an open mind. Once we reach the roughly neutral level, we can then decide should we stay or should we go. That is, we can then judge whether we should stay at neutral or we should move further to the stimulative territory — that depends on the economic outlook when the times comes when we will have to decide the matter.

Even when we perceive that we might be leaving restrictive territory and reaching neutral, we may not fully know it. And that's, again, related to the significant uncertainty of the concept of neutral rate. So this is, in my view, a strong argument in favour of maintaining freedom of action.

I think it's important to combine communication on direction, as we have done, but maintain freedom of action because we simply don't know if certain risks still materialise, such as weaker growth due to protectionism or sticky service inflation and/or higher energy prices. So we have to be mindful to both directions.

Is this part of the ongoing ECB strategy review?

Rehn: In our latest strategy review of 2020/21, we revised our inflation target, which was a consequential decision. We moved from “below but close to 2%”, which was perceived as a ceiling, and had a downward bias and contributed to the deflationary environment, to this symmetric 2% over the medium term.

It was tested immediately and has served us well, because we didn't have to suddenly and forcefully try to tame inflation with potentially vast societal and economic consequences. And that's why the medium-term definition is also very important. 

For these reasons, we should not again revise our inflation target. And I believe that there is a fairly broad consensus on this.

But we have to analyse the inflation dynamics of the recent surge and stabilisation. And one factor there is that in the US and in in the euro area, we had a somewhat different experience. What we have to analyse is not only the supply side shock and factors, but also the demand factors in that context. In hindsight, we somewhat overlooked the pent-up demand facilitated by a strong and forceful monetary and fiscal stimulus within the context of supply side bottlenecks, which later probably contributed to the stickiness of inflation. And you can see this now in the US, in particular, even more than in Europe.

So in other words, monetary and fiscal policymakers have to have an open mind and be self-critical. And that's why it merits to look at monetary-fiscal interaction with fresh and open eyes.

How concerned is the Governing Council about the economic situation in Germany?

Rehn: We are certainly concerned, because it's affecting the rest of the Eurozone, including Finland. And also about France. One interesting phenomenon, by the way, is that my southern European colleagues have become more confident about expressing their own good economic performance, which I don’t mind at all. Their reforms are paying off.

I would assume that Germany will be able to revive its economy again as it has done before. But that requires political stability to support economic reforms, not least in the energy sector and concerning the debt brake. We've also followed energy prices in the Eurozone and in the US. And compared to the pre-COVID period, and they are roughly double in Germany, the manufacturing machine of Europe.