“I am optimistic that we will be able to avoid a severe economic slump” Interview published in Zeitschrift für das gesamte Kreditwesen (ZfgK)

Interview conducted by Philipp Otto.
Translation: Deutsche Bundesbank

Mr Nagel, in the face of a “perfect storm” of war, inflation, recession, tensions in trade relations, mounting interest rates and the like, what worries you most about where society and the economy are heading in Europe and Germany? Or is it all these factors in combination?

These challenges are all interconnected, of course. Russia’s war against Ukraine and the energy crisis it sparked are one of a number of reasons for the high inflation. Increased prices and distinct uncertainty as to further developments are leading many people to cut back on consumption. It’s mainly those on low incomes who feel the impact of high inflation. High prices and uncertainty are also placing a strain on enterprises’ output, especially in energy-intensive industry. All these factors in combination are reinforcing widespread and justified fears that economic activity will decline. Yes, the higher interest rates are also a drag on the economy. But they are needed to tame inflation. As President of the Bundesbank and a member of the ECB Governing Council, it is my job to face up to this multifaceted situation and ensure that the high inflation comes to an end and does not become entrenched. 

Have central banks in Europe already lost the battle against inflation? Even the Bundesbank is expecting inflation to hit rates of 6% and more next year in Germany and Europe. What gives you hope?

Correction: we are now even expecting inflation in Germany to exceed 7% on average in 2023, as measured by the Harmonised Index of Consumer Prices. Inflation has turned out to be more stubborn than most experts had been expecting, and I’m also referring to the Bundesbank when I say that. But I have no doubt that stable prices will be restored. The ECB Governing Council has taken decisive action by raising the key interest rates for the fourth time in succession in mid-December. That said, we should all be aware that monetary policy measures need time to fully feed through to prices. My colleagues and I on the ECB Governing Council are expecting the inflation rate for the euro area to decline this year and in the two coming years. But not yet at a sufficiently strong pace to reach our target of 2%. For me, that means our job is not done yet. We need to take further action. 

But the German public’s inflation expectations are still very high, according to recent surveys. Why is the ECB now barely able to influence inflation expectations?

Short-term inflation expectations are indeed very high. But what matters for monetary policy is that medium and long-term expectations remain firmly anchored. Take a look at experts’ longer-term inflation expectations: they are now perceptibly higher, but still close to 2%. Furthermore, we see risks – medium-term inflation expectations are responding ever more strongly to current price developments. Another thing that concerns me is that our monthly surveys of firms and households are showing a significant increase in long-term inflation expectations as well. I firmly believe that we need to take further monetary policy action to halt and reverse this trend.

How strongly are inflation rates diverging in Europe right now? Does that complicate efforts to tame inflation?

Inflation rates in the euro area are highly divergent. They are currently lowest in Spain, France and Malta, mainly because energy prices there have been capped heavily by policy measures, and they are highest in the Baltic countries, which has to do with the geographical proximity to Russia. That certainly doesn’t make things any easier for monetary policy. The ECB Governing Council can’t conduct monetary policy for particular countries. Rather, we shape monetary policy for the euro area as a whole.

Is there any robust historical evidence that shows how strongly interest rate increases impact on economic activity? What factors does this depend on?

Interest rates have never been increased this strongly since the euro was introduced, which is why we need to look at different regions or past experience. In the Bundesbank’s history, there have been three periods which saw interest rates rise very sharply within a short space of time: two in the 1970s in the context of the two oil crises, and one in the early 1990s, when inflation picked up strongly in the wake of the reunification boom. This response may have dampened growth and led to rising unemployment, but the Bundesbank succeeded in lowering inflation again. How a restrictive monetary policy plays out will always depend in part on the state of the economy and what is driving inflation. It’s important whether inflation is being driven more by demand or supply factors, for instance. Or whether it is being influenced more by domestic price pressures or global developments. Acting too hesitantly now for fear of choking off economic activity would be the wrong course of action. Then we would be forced to tighten policy all the more sharply further down the line, thus placing even more of a strain on the economy. That would be the case, say, if there were a broad-based rise in prices and wages, which might increase the likelihood of inflation remaining persistently higher.

Are you already seeing the first signs of a wage-price spiral?

At the moment, we are seeing the trade unions put high demands on the table, understandably so given how high inflation is at present. However, experience has shown that actual wage settlements tend to be lower than what the unions originally demand. Indeed, up till now, most wage deals have been below the rate of inflation. And some negotiated settlements have also made use of tax-free one-off payments. So we’re not seeing any sign of a wage-price spiral at present in the sense of current wage settlements adding to inflation – if anything, it’s more of a price-wage spiral. Even so, there is a distinct risk of stronger second-round effects because the higher wage deals that are being reached could prolong the prevailing period of high inflation rates.

Is the sustainable transformation of the economy also driving inflation? Are the high levels of investment not being passed through to consumers via prices? What can be done to tackle this?

Climate change itself and also the transition towards a climate-neutral economy certainly d. h.ve an impact on inflation. Carbon pricing, for example, is the key policy tool for reducing carbon emissions, and rightly so. It does, however, push up prices both directly and indirectly. Investment in new production technologies causes inflation indirectly, partly because it spurs demand for necessary components and raw materials. But there are also effects that work in the opposite direction. For example, it is now cheaper to generate power from renewable energy sources than from fossil fuels, so energy prices are more likely to decline in the long run. On balance, then, the impact is not quite so clear-cut.

What’s your mood as the new year gets under way?

I have been Bundesbank President for a year now – I couldn’t have imagined all the things that could happen in the space of a year and how challenging the situation would be. That said, I am optimistic that Germany will be able to avoid a severe economic slump and we will get off lightly with a mild downturn. And I am confident that we will be able to tame the high rate of inflation over the medium term. The ECB Governing Council is very aware of its responsibility.

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