Interview Klaas Knot with Nikkei

The current tensions in the Middle East have kept oil prices high. How big a risk do you see this for ECB's monetary policy? 

At this moment it seems as if the oil price increase is still contained. Unless there is a major escalation of the conflict in the Middle East, I don't think it will have an awful lot of impact on the economic outlook. It'll have some impact through somewhat higher oil prices and maybe also higher shipping costs because of the impediments in the Strait of Hormuz. That will have the potential to lead to slightly higher commodity prices and therefore slightly higher headline inflation. But I wouldn't overestimate the impact of it since this is all taking place against the backdrop of a general decline in inflation, predominantly in food and goods inflation.

You see the risk as limited?

For the moment I see the risk as limited, but then again, we know that geopolitics in the Middle East is quite unpredictable, it can change very rapidly. 

What would you do if the price rises to 100 dollars per Barrel?

It's hard to say. Oil prices will become relevant for us the moment that they were to increase so much that there is a significant risk of second round effects through wages. In and of itself, an oil price shock tends to be a temporary shock. We've seen many, many episodes in the past of turmoil in the Middle East that always led to an increase in oil prices. But usually after a few weeks or months oil prices came down again. If that pattern would repeat itself, then I think the impact will continue to be muted.

We should be on alert the moment the impact in oil prices is both sufficiently significant but also significantly permanent to be able or to have the potential to trigger second round effects in wages. If that happens then, definitely we would have to respond. It is about intensity plus duration, not just about the level of the oil price.

What do you think of the risk that high commodity prices will put strong pressure on wages again?

I am increasingly confident in the disinflation process. I'm increasingly confident that we are going to converge toward our two percent target over the medium term. But a crucial prerequisite for that is that wage growth and, in its slipstream, increases in unit labour cost will gradually come down. They will continue to increase at a rate well above two percent. So, real wages will continue to increase but that's logical for this late stage of the inflation cycle. But these real wage increases will have to be absorbed by lower profit margins. And so that is a crucial constellation that needs to develop in line with the return to our two percent inflation target.

Do you feel more confident that wage trends will slow down as expected?

We see the initial signs of a decline in wage pressures, so that is absolutely good news. Fortunately there is also still room for maneuver in profit margins to absorb some of these higher unit labour costs. But of course, that room is not infinite and there is a limit to the extent to which a profit margins can absorb higher unit labour cost. The momentum is going in the right direction, but then again, wages are still going up by around five percent at the moment. To be compatible with our two percent inflation target plus half a percent productivity growth, wage growth will need to come back to around two and a half percent over the medium term..

The ECB governing council has signaled cutting rates in June, but it depends on the data.

If the data on the labour market and inflation come in as projected, showing a further, gradual decline in wage and price pressures, then I think it's realistic to assume that we will begin to take our foot off the brake, so to speak, by making a first rate cut in June.

Financial markets want to know what the path will be after the ECB starts cutting the rates. Will it interrupt once it has started to cut rates? Or could there be a series of rate cuts? What is the preferred path for you?

I think that we will have to take a cautious approach after June. And the reason for that caution is that every quarter, we will have to see this projected decline in unit labour cost actually taking place. The whole constellation of unit labour cost and unit profit margins will have to develop in line with our timely return to two percent inflation. That still requires quite an ambitious deceleration in unit labour costs. So, we will have to establish every quarter whether  progress is still in line with our projections. As long as that is the case, we can continue to cut rates also after June. But for after June, I would say: no pre-commitment to any specific time path. 

Do you mean that you should wait until the September's meeting?

It is too early to say anything on any meeting beyond June. But it is clear that, every quarter, we will have an additional data point on the labour market going into a fresh round of projections and that will be an important piece of information for us to recalibrate our policy settings.

ECB is totally independent, but the FED may delay cutting interest rate. If the euro exchange rate falls, it will increase inflationary pressures through import prices.

We're still in the process of generalized disinflation., If the euro falls that would be a bit of an unfortunate, new source of imported inflation. But I would immediately go on to say that it depends very much on what the source of the euro depreciation would be. If the source of the euro depreciation is tighter monetary policy by the FED, then that tighter monetary policy will also likely lead to higher bond yields across the globe spilling over to the euro area and that spillover will be disinflationary. You never should look at the exchange rate in isolation, it is only one input into our inflation outlook and if the source of the movement in the exchange rate is tighter US-monetary policy there are of course wider spillovers than just the exchange rate. In general, I therefore think this factor should not be overestimated. 

Can you say that you won the fight against inflation?

I want to be cautious here and avoid any premature declarations of victory. The experience of the United States in the last three months has reminded us that we should still be vigilant. I am very satisfied with the progress that we've made so far and I'm increasingly confident that we will get inflation back to two percent. But we are targeting a sustainable convergence toward our two percent target and it may well be only in the course of 2025 that this condition can be established. Until then, the fight will not be over.

Related to the economic situation in the euro area: the new number of PMI was stronger than market expectations. Do you expect demand to be stronger? 

This was a very encouraging sign that the recovery that is in our projections is actually going to happen. What is in our projections is a mild recovery in the first half and an acceleration of growth in the second half of the year. And we have now had a string of monthly PMI data gradually improving, and that provides us also with more confidence that demand is indeed strengthening again. The further we go into the year 2024 the stronger I expect the stimulative effect from increases in household purchasing power, as  average wage growth will clearly exceed average inflation.

Do you worry about the second-round effect related to these numbers?

No, this recovery in GDP and in real wages is all in line with our projections, which nonetheless exhibit continued disinflation. Hence, the two can go hand in hand.

There have been some problems of the management in the United States Banks and also in Switzerland, but this has not led directly to global risk at the moment. As the FSB chair, what are the financial system problems you are concerned now?

When it comes to global financial stability, I should say so far so good.  The rapid increase in interest rate has been a massive shock to the financial system that has been absorbed relatively well. Going forward, financial stability risks from high indebtedness will gradually recede as interest rates are projected to come down again.

We have managed to engineer the disinflation without any major run-up in unemployment which is unprecedented, historically. But that assumes that the last mile in the US and the last kilometer in Europe will proceed as smooth as the previous miles in the US and the previous kilometers in Europe. If disinflation were to stall and interest rates would not come down as quickly as currently priced in by the markets,  some potential issues around highly indebted counterparties and overly rich market valuations might resurface. 

Do you see any risks of fiscal policy or fiscal problems in other countries in EA?

It is clear that we definitely need fiscal consolidation in Europe. Fiscal policy became quite stimulative in response to the pandemic and the energy crisis and this was all very well understood. But debt levels have ratcheted up and governments are beginning to run out of excuses to further postpone fiscal consolidation. There's a significant challenge ahead for a number of countries  that cannot continue this fiscal stance for much longer. Even if interest rates will come down again once the ECB starts taking the foot off the brake, they will  unlikely go back to levels before the pandemic. So, that means that countries will have to run a structurally higher primary fiscal surplus to be able to afford the higher interest rate burdens. At the same time, if the euro area economy recovers as projected, this would open up a window for some front-loaded fiscal adjustment.