Joachim Nagel: Do not loosen monetary policy too soon
Addressing the European Banking Congress in Frankfurt am Main, Bundesbank President Joachim Nagel explained the link between Christmas biscuits and monetary policy. He cautioned against any premature easing of the tight monetary policy currently in place in the euro area.
According to Bundesbank model estimates, the tightening can be expected to have its maximum impact on economic activity in 2023 already, and on inflation only in 2024, he said.
In other words, much of the inflation-dampening effect induced by monetary tightening is yet to materialise. But we need it to materialise. And it will only materialise in full if we let it work.
Mr Nagel likened loosening too early to switching off the oven before your Christmas biscuits are done. Once you notice that they are underbaked, you have to heat up the oven all over again and end up using a lot more electricity, he elaborated. That’s why the key interest rates will need to stay high for long enough to bring about a lasting fall in inflation.
While it is impossible to predict exactly how long this period will be, it is highly improbable that it will end anytime soon. Mr Nagel remarked.
The Eurosystem’s tight monetary policy
In 2022, euro area inflation was the highest it had ever been since the launch of the single currency. October 2022 saw euro area inflation, as measured by the Harmonised Index of Consumer Prices (HICP), reach 10.6%. With a view to taming the high inflation, the ECB Governing Council raised key interest rates by a total of 450 basis points between July 2022 and September 2023. Since then, inflation has fallen significantly. In October 2023, it stood at 2.9%.
In his speech, the Bundesbank President also described how the current tight monetary policy affects first the financial markets, then the economy and ultimately prices. Experts refer to this process as the monetary policy transmission mechanism.
Banks benefiting from customers’ behaviour
Mr Nagel pointed out that interest rates in banks’ lending business have been adjusted faster than those applying to deposit business, meaning that banks have been able to bolster their profits. Lending rates for loans to enterprises and housing loans have risen significantly. The tightening of monetary policy is reflected in both lower credit demand and a drop in the credit supply.
Yet, the slowdown in lending is in line with what our models would have suggested based on patterns observed in the past, Mr Nagel commented. He added that interest rates on overnight deposits have also risen less sharply than those applied to time deposits. While this has prompted many customers to shift funds out of overnight deposits into time deposits, there is still a large stock of overnight deposits, so banks have been benefiting from their customers’ sluggish response.
Mr Nagel also raised the point that the increasing remuneration of the excess reserves that banks hold with the Eurosystem might hamper monetary policy transmission. Bundesbank researchers, he said, had found that the loan supply of banks with large amounts of excess reserves reacted less strongly to the recent interest rate hikes than the loan supply of banks with low reserves.
In other words, the increasing remuneration of reserves may impede transmission, all else being equal. Increasing the ratio for minimum reserve requirements, where the remuneration rate was recently set at 0.0%, could counteract this effect.
All in all, though, monetary policy transmission across financial markets is working well at present, Mr Nagel remarked, adding that there can be no talk of overtightening.
Dampening of aggregate demand inevitable
Mr Nagel went on to talk about the impact of monetary tightening on the economy. A dampening of aggregate demand is inevitable if tight monetary policy is ultimately to bring prices down. He cited unusually stable labour markets, favourable indebtedness levels among firms and households, and strong investment activity as factors supporting the economy. Against that backdrop, he expressed optimism about the chances of avoiding a hard landing for the economy.