The European Central Bank needs to be wary of cutting interest rates too far as borrowing cost are already near a level that no longer restrains the economy and going lower could backfire, according to Executive Board member Isabel Schnabel.
Officials can continue to loosen monetary policy, but should do so only gradually to avoid taking rates below the so-called neutral threshold, Schnabel said in an interview. Easing too much could squander valuable policy space, she said.
Ms Schnabel has traditionally been cautious about when to cut rates, putting her at the so-called hawkish side of the executive board.
“Given the inflation outlook, I think we can gradually move toward neutral if the incoming data continue to confirm our baseline,” Schnabel said in her Frankfurt office. “I would warn against moving too far, that is into accommodative territory.”
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She estimates neutral, which can’t be precisely measured, at 2 per cent to 3 per cent – higher than more dovish officials like Greece’s Yannis Stournaras and Portugal’s Mario Centeno have suggested. With the deposit rate standing at 3.25 per cent following the three quarter-point cuts so far this year, Schnabel said “we may not be so far” from it now.
The remarks feed an intensifying debate about how the ECB should react to a deterioration in the euro-zone economy alongside inflation that’s approaching 2 per cent target more rapidly than previously foreseen – but not without leaving pockets of concern.
Discussions over the pace of easing are becoming heated, complicated further by heightened global uncertainty – especially from the trade tariffs that will likely accompany Donald Trump’s return to the White House.
Investors expect rates to fall to about 1.75 per cent next year, which Schnabel acknowledged is at odds with her own assessment.
“Markets seem to assume that we will need to move into accommodative territory,” she said. “From today’s perspective, I do not think that would be appropriate.” She also dismissed investor speculation on half-point moves, saying she has “a strong preference for a gradual approach.”
Even if inflation were to fall short, cutting rates could prove counterproductive if underlying economic problems caused the undershoot, she cautioned.
“In such a situation, the costs of moving into accommodative territory could be higher than the benefits,” Schnabel said. “We would use valuable policy space that will be needed in the future when the economy is facing shocks that monetary policy can deal with more effectively.”
On growth, she played down this month’s surprise drop in private-sector activity, citing elevated uncertainty stemming from political troubles in Europe and Trump’s election victory in the US. The figures may overstate the extent of the weakness, she said.
“In combination with hard data, the surveys suggest that the euro-area economy is still stagnating,” Schnabel said, adding that she didn’t see the risk of a recession at the moment. “Consumption in the third quarter, as far as we can tell on the basis of the available data, was stronger than expected. We see some evidence of a consumption-driven recovery in the data. This gives me confidence that this narrative remains plausible.”
That view stands in contrast to last week’s appraisal of the outlook by Italian central-bank Governor Fabio Panetta, who urged a greater focus on the “sluggishness of the real economy” and said rates are probably “a long way” from neutral. He reckons policy may have to become expansionary – even if others see such talk as premature.
There’s growing proof that the impact of the ECB’s tightening campaign is “fading visibly,” according to Schnabel. A recent survey showed most banks no longer think rates are holding back loan demand and the housing sector seems to be bottoming out, she said.
While the neutral rate is probably higher than before the pandemic, “we’re also in a very different world,” Schnabel said.
“We have much higher public debt, more fragmentation and significant investment needs to tackle the challenges we are facing,” she said. “And we also have a potential productivity boost from the AI revolution.”
As for inflation, Schnabel is confident of reaching 2 per cent next year – despite still-elevated price pressures in the services sector. She cautioned, however, against fixating on precisely when the goal will be met, saying the journey may remain “bumpy” in 2025.
Some officials warn that price growth may become too weak if rates stay high for too long, with Bank of France Governor Francois Villeroy de Galhau saying last week that officials will pay “close attention” to such dangers.
Schnabel doesn’t consider that a significant risk, and expects the ECB’s December projections to show inflation remaining “close to our target over the medium term.”
While Trump’s comeback is another headache for the ECB, the limited information on what he’ll actually do means it’s too soon to draw conclusions, she said. Tariffs would jeopardise growth, but the price implications are less clear, Schnabel said, adding that greater protectionism should – on balance – have some inflationary effect. – Bloomberg
