Tomas Hirst on the State of ECB Policy and the Eurozone Economy

As future inflationary trends remain uncertain across Europe, the ECB must walk a tightrope when considering further rate hikes.

Tomas Hirst is a macro analyst in the Strategy and Allocation division at LMI and formerly worked at Credit Sights, an independent fixed income research company, where he led the European strategy team covering Euro and sterling credit markets. Prior to that, he also worked at Bloomberg and the World Economic Forum in Geneva. Tomas joins David on Macro Musings to talk about the Eurozone economy, the ECB, and the future of the Euro project. Specifically, David and Tomas discuss the macroeconomic state of post-pandemic Europe, the rationale behind the ECB’s rate hikes, the inflation expectations conundrum within the Eurozone, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Tomas, welcome to the show.

Tomas Hirst: Thanks very much David. It's great to be here.

Beckworth: Great to have you on and you're someone that I have grown to know over the years via Twitter. Hopefully Twitter will still be with us in the future.

Hirst: Fingers crossed.

Beckworth: I recently discussed this with Noah Smith, our past guest, what will we do if we lose Twitter? But it's been great to meet you, to engage with you. It's always fascinating to meet people across the pond, as they would say, who are covering Europe and the US and bring a perspective in that sometimes Americans like myself don't fully appreciate. And I'm excited to have you on Tomas, because I want to get into Europe. I've been a little critical of the ECB's monetary policy, but I'm saying this from over here across the Atlantic. You're there, you're on the ground, you're covering it. So I'm looking forward to your thoughts on it. And let's begin first with maybe informing us, telling us what has happened in Europe since the pandemic. Are there any similarities, differences to what we've experienced here in the US?

The Macroeconomic State and Fiscal Response of Post-Pandemic Europe

Hirst: Yeah, thanks. I mean, I think it's been a very unusual last couple of years everywhere. And so to the extent, even in the similarities, I'm sure we could pick out some pretty unique trends. But I would say overall the picture is in 2020 we had very aggressive lockdowns right through much of Europe and these had the same sort of stop-start dynamics that we also saw in the US. But they persisted a little bit longer in Europe relative to the US and they were a little more stringent later in the day. I think other similarities is once we started reopening, we saw the same short term dynamics. There'd been a very large buildup of what was called excess savings. In Europe, this was predominantly done through the fact that incomes were protected through furlough schemes, but consumption had collapsed.

Hirst: So households built up this stock of savings and as soon as sectors started reopening services in particular, that spending started to chase those activities. So we saw that big reopening, pent up demand bid through Europe and that was really the story of much of 2021 and going into this year as well. And I think there's obviously very strong similarities there. Elsewhere, we've obviously seen other global factors at play, supply chain chokes that were related to those reopening and shutdowns have impacted the Eurozone economy, particularly the large industrial bases in core Eurozone countries like Germany where we still have the auto sector that hasn't seen volumes pick back up to pre-pandemic levels even after this amount of time has elapsed. And more recently though, I think this is actually where we're going to come up against some of the key differences here. We've also seen the energy story play out, although in Europe that energy story has obviously been much, much more acute and has a much bigger explanatory power over say inflation and consumption dynamics that we're seeing than I think is true of the US.

Beckworth: So let me go back and ask about the policy response during this time. So in the US we had very large, very generous fiscal support, unlike we had any time before, definitely not like 2008. And one of the big critiques now looking back, is the additional fiscal stimulus we got in 2021, the American Rescue Plan, which added another $1.9 trillion on top of what we had already received in 2020 and all this support through 2021 was excessive. And just looking back, that was a $1.9 trillion package. The CBO at the time said there was about a $400 billion output gap, so just doing the math. This is the critique Larry Summers and Olivier Blanchard and Joe Gagnon, who we just had on the show, they mentioned in early 2021. Now I got it wrong. I called low inflation, we had high inflation. But a key part of the story here was this really generous fiscal support, and of course the Fed accommodated that. But over in Europe, was there anything similar size? Because my impression is you guys did not have as big a fiscal package, or am I wrong?

Hirst: Well, so there's a couple of strands to bring out. In terms of the direct transfers, the way that Europe's pandemic response was mostly structured was through things like furlough schemes whereby workers maintained their employment, they were effectively paid to stay at home, but continued their relationship with their employer. But those furlough schemes were typically set at something like 60 to 80% of the wage you would otherwise have earned. So if you imagine that income line, it is actually an income sacrifice of between 20 and 40%, but your consumption fell more like 80% and that's where you had those excess savings built up. In countries like Germany, there was actually a preexisting scheme for this short time work. And what that scheme does, the Kurzarbeit system is effectively… you can split your existing job with other employees so you reduce your hours and you get paid… there’s a floor of the salary you get paid.

Hirst: So in other words, there was some salary sacrifice, but you were paid to stay at home. There was not a situation as we saw in the US where workers were paid more than their [inaudible] salary. That did not happen at any point. In the UK we had quite a generous one that sat at about 80%, but even there, it was somewhat less generous. About halfway through 2020, there were active debates about whether or not those schemes in and of themselves were too generous. So there was a moment in September 2020 in the UK when they were going to scrap the furlough scheme and introduce a second scheme that would have been much less generous. And it effectively was the government putting their hands up and going, “maybe the pandemic's with us forever, maybe we're never reopening and this is the model we want to use.”

Hirst: It would've had a huge impact on unemployment. That was two months before the announcement of the vaccines and only a few months after that before they were actually in people's arms. So thankfully we avoided some of the worst case scenarios there and those schemes were in place. And I think the other point to draw out is that there is some fiscal support coming down the track in the form of the so-called NextGen EU recovery package. And the really interesting thing about that is the money for it was raised centrally in Europe, which is very unusual. So that it was raised at European commission level, not at member state level. So if your listeners recall, the Eurozone tends to be funded. Each member state has commitments to the center, but they fund it at member state level and then pay into a central pot.

Hirst: This one was raised at a central level and then guaranteed by the member states. Second interesting thing about this is it involves net transfers from states that did relatively better out of the pandemic to states that did relatively worse. In other words, there are net transfers from the large core economies to the periphery economies in general. It's not quite as clean as that, but in effect, countries like Germany and France for example, are net contributors to the scheme. And countries like Italy and Spain are net recipients of money flowing out. And that's very interesting because I think it's one of the reasons why people are a bit more sanguine about the prospects for the Eurozone over the next few years, especially in light of the energy crisis that the region's currently going through.

Hirst: Because there's some sort of structural demand being put into the economy to protect the domestic economy, which is coming from this fund, and it is relatively sizable. So I think that gives some hope that the worst case scenario can be avoided in terms of the scale of a downturn. And also that there is now a central funding mechanism that's being created in case of future fiscal problems, such that the Eurozone now has not only the ECB as a backstop, but also the European Commission’s joint-and-several bond issuance as a potential backstop.

Beckworth: So that's really fascinating because one of the critiques of the Eurozone from the very inception was it's not an optimal currency area. It doesn't have a true fiscal authority. The US, we have the US Treasury Department, which effectively transfers resources from a high income state like Texas to a low income state like Michigan via different social welfare spending programs. And that's been one of the critiques, at least in Europe, you need a shock absorber like a fiscal transfer or you need great labor mobility. If you don't have those, you need a perfect business cycle alignment which doesn't exist. I guess Tomas, are you then hopeful this is the beginning of a more solid and maybe even a future meaningful fiscal authority in the Eurozone area?

Hirst: Yeah, I mean, especially on the basis of that old adage, there's nothing so permanent as a temporary solution. I think the Eurozone has tended to evolve one crisis at a time. It's kind of tragic, but it's true. And I think this particular one will prove much the same as previous rounds. We're already seeing it in fact, simply because of the debt ramp up that we saw over the pandemic, it has become necessary to revisit the debt and deficit criteria that were baked into the so-called stability and growth pact, which requires states to drift back towards 60% debt to GDP. That doesn't seem very plausible over any reasonable timeframe from here. And in revisiting that, there is hope and there is some expectation that more flexibility can be baked in and that there will be more, sort of, collective responsibility.

Especially on the basis of that old adage, there's nothing so permanent as a temporary solution. I think the Eurozone has tended to evolve one crisis at a time. It's kind of tragic, but it's true. And I think this particular one will prove much the same as previous rounds.

Hirst: So rather than having hard and fast rules that force countries that drift away from those targets into very, very crushing internal devaluation as we saw after the Eurozone sovereign crisis in 2011, 2012 that caused basically a decade of economic underperformance in countries like Italy and to a certain extent, Spain. And that was associated with extremely high levels of things like youth unemployment that nobody could say is really adding to long term potential. This would hopefully be a moment where the Eurozone actually gets its act together a little bit on these things, bakes in some flexibility into that criteria and also has a mechanism for avoiding deficit or debt built cascades within a country itself, where they're trying to chase down these deficit targets and they're doing it by destroying domestic demand and that just creates more of a problem.

Beckworth: So speaking of domestic demand, one of the big differences between the Eurozone and the US economy, at least ones that I've followed, and I know you look at private and domestic demand, but I like to look at total nominal demand. I think it's a good useful measure if we don't truly know what the output gap is or we really don't know the what U star or Y star is, these kind of unobservable latent variables. So I like to just look at, in the case of the US, the total dollar size, where is it? And if you look at it relative to the growth trend it was on pre-pandemic we're about $1.3 trillion higher or above in just pure dollar terms than where we would've been had there been no pandemic. And so that suggests to me there is some definite excess demand overheating. If I look in Europe, I don't see that it, it's barely back to its trend. And you could argue if it's even there, but roughly back to its trend.

Beckworth: And the other thing that's also useful to look at is a forecast, what do forecasts show? And forecasts show the US is still going to be above this pre-pandemic trend and eventually this trend becomes something you don't want to rest all your hopes and plans on. But it's a good benchmark, a starting point to think about, are we growing faster than trend or not? And in Europe we don't see that, which suggests to me, and I think we'll get to this, is all of the inflation or most of the inflation is supply side driven, energy driven. Is that a fair interpretation?

Hirst: I think it is an extremely fair interpretation, and you're quite right. When we get to it, you'll see me probably tearing my hair out because it's one area where people quite like to draw similarities where I only see difference. It is very, very clear… so the headline GDP level as you say, we are back touching pre-pandemic trend in Europe. But if you strip out the private demand line, we're barely back at the pre-pandemic level, let alone the pre-pandemic trend. And so as fiscal steps off, and we expect fiscal to step off the extreme amounts of accommodation that we saw in the last few years, even with the NextGen EU money going out, private sets of demand needs to step up. But it's being asked to step up at a moment where Europe is facing very extreme pressures on household budgets because of the energy crisis.

Hirst: And industrial production is under pressure as well. It's actually been remarkably resilient, but it seems very difficult to imagine with input prices shooting up that they can continue to operate at the levels that they were until that is at least in a more manageable state. And I worry then that we are relying on things like excess savings, which I think actually is one of the interesting... this is a point of difference that not enough people, I think, focus on. We draw these lines across charts and say look, this is the pre-pandemic savings trend. This is the savings that we saw, the flows that we saw over the pandemic. And the sum of that is excess saving. Two things there. One is that that line we've drawn across the chart is just a completely artificial trend series for what desired savings are. We just made that up.

Hirst: So we have no idea how much of the additional saving that was done over that period is excess. Second point is the distribution of those savings. If we had the same kinds of excess savings in Europe as there has been in the US, where is it and why hasn't it come to the fore yet? Why haven't we seen above trend demand in a period where households are richer apparently? And my contention is that the distribution of those savings are such now that it's very, very likely they sit with very high income households. And as rates rise in Europe, it's even more likely that the MPC of people with those savings is going to be extremely low, and we may never see a good chunk of those savings coming back into the system. They may just be held in financial securities which have finally positive yields in the Eurozone. And I think that seems [to be] a story that is more consistent with the data that we've seen. And if we're banking on those excess savings saving the day here, I think that's a very poor wager.

As rates rise in Europe, it's even more likely that the MPC of people with those savings is going to be extremely low, and we may never see a good chunk of those savings coming back into the system. They may just be held in financial securities which have finally positive yields in the Eurozone. And I think that seems [to be] a story that is more consistent with the data that we've seen. And if we're banking on those excess savings saving the day here, I think that's a very poor wager.

Beckworth: Alright. So let's move to the key actor in this story, and this is the European Central Bank. How is it interpreting this data? And I think it's fair to say it probably makes the same observations we do, but it places more concerns on this unanchoring of inflation expectations. And in fact, I was just reading the speech by Philip Lane, the chief economist for the ECB, and he says at worst we'll have a mild recession. So he's very optimistic. But before we get into all of that and your critique of their view, for the American listeners like myself, it might be useful just to go over some of the basics. So the ECB has a governing council, and as I understand it, there's six members of the executive board, so the president, Christine Lagarde, Phillip Lane, the chief economist I just mentioned, and then there's 19 governors from the member country. So they all come together and they meet. It's like the FOMC, is that right?

The Background and Politics of the ECB

Hirst: That's exactly right. Yeah. They're the rate setting body of the ECB.

Beckworth: And each country gets one vote, is that right, on monetary policy decisions?

Hirst: Yes. Each country gets a vote, but of course some of the executive board can be representatives in effect-

Beckworth: Fair enough.

Hirst: But they don't vote in line with their country, they represent the ECB in that vote.

Beckworth: As a whole. But I find that interesting because you have little countries like Estonia, Luxembourg, Lithuania, and each of those countries have an equal vote to Germany and France, right?

Hirst: Yes. And as you read in the minutes, it's always fully consensus.

Beckworth: Okay.

Hirst: Think of that what you will.

Beckworth: It just reminds me of some of the debates we have in the US about our US Senate. Each state gets two senators, even a state like Wyoming, which has very few people with a state like New York, which has millions. And there's this sense of it's not fair that Wyoming gets the same number of votes, say, as New York. Of course, the other side holds, well, it's not fair for New York to control everything either. But my point is I would be surprised if there's not any discussion about that. Why does Estonia get the same vote as Germany? Has that ever come up, the politics of that?

Hirst: Oh, yeah. I mean, this is a constant point of discussion, the relative weighting of countries in the institutions and how that plays out. Another thing that's been obviously very interesting over this period is the ECB has had to act as effectively a de facto backstop to Eurozone debt markets on a number of occasions, most recently March of 2020. And in doing so, it has done something that equates to mutualization by proxy and not every country represented on the governing council is thrilled and they don't necessarily feel that using the central bank balance sheet as a mutualization tool is a particularly democratic way of going about these things. The problem has been to date there's been no alternative than that.

Hirst: And that's, as I was saying earlier, why this joint-and-several bond issuance at commission level is quite interesting. Because you can tie that to conditionality and you can set disbursements on a schedule and say you can't get the next chunk until you demonstrate you've done X or Y or until you've complied with the targets we set you at the start of this program in a way that they cannot set limits on the ECB in that way because obviously the ECB is guided by its mandate and anything that is inconsistent with it achieving 2% inflation over the medium term will be anathema to them in theory.

Beckworth: So the ECB has this governing council. There's probably lots of interesting trading and politicking going on behind the scenes we don't know about. They come together to make their decisions and over there, there are some key interest rates. Let me read off the ones that I'm aware of and you tell me which ones are the most important, but you have a ceiling interest rate, the marginal lending facility rate. So it would be like the Fed's discount window here. At the very bottom you have a deposit facility rate like the interest on reserves for banks in the US and then you have a main refinancing operation in the middle. So you have a corridor, try to keep the overnight rates somewhere between those two extremes of the ceiling and the floor, the marginal lending facility and the deposit facility. But when you are over there and you're talking shop with other people in your space, Tomas, is there a rate? Do you talk about the main refinancing rate or you talk about some other rate? Which one is the rate, if there is one?

Hirst: So historically it was the main refinancing rate because that was the one that was closest to the market experience of what the risk free rate was, right? In a world awash with excess reserves in general, you've got to look at whatever the bottom rate is, and that is the deposit rate. So now the marginal rate is the deposit rate. So the reference rate that you'll see spoken about is always that, which is set at one and a half at the moment.

Beckworth: So that's interesting and also to kind of put things in perspective, so that deposit rate... Well, I guess all the rates there, they've all gone up about 200 basis points. Is that right?

Hirst: Yeah. From minus 50 bps to 150 on the deposit rate.

Beckworth: So the deposit rate was at minus 50, we started at zero here in the US. So the Eurozone has had two percentage points or a 200 basis point increase. We've had 375, likely have another 50 basis points here in December. And the ECB has a meeting coming up, right, here in December as well? And what are they likely to do?

Hirst: We almost guarantee to see another 50, so that seems pretty nailed on now. They've given us no indication that they are inclined not to do it, in other words.

Beckworth: All right. And they started in July whereas the US, the Fed started in March. So a little bit slower but also very different, I think, inflation story, which is a nice segue into, let's talk about these decisions. So we've had rapid interest rate increase, target interest rate increases in the US and in Europe, likely 250 basis points by the end of the year and are they justified? And what is the ECBs motivation for doing it? So maybe you can walk us through, what is the ECB's thinking, rationalization, and what is your critique of it?

Explaining and Critiquing the ECB’s Rate Hikes

Hirst: So post pandemic, we had a moment of soul searching. This is coincided, I think, with a global developed market soul searching where you had… the Fed decided that it was going to launch FAIT and take a more flexible approach to short term overshoots. Europe had a similar thing. So historically the inflation mandate was close but below 2% over the medium term, which in practice meant anything above one and a half would probably do. That was decided to be an unhelpful way to communicate a symmetrical target. So they ditched that “close to” language and kept 2% over the medium term. And the idea of this was to give them some flexibility to be able to see through particularly non-domestic drivers of inflation. So things like energy, things like food prices, be able to part those and go, well, I know it's in our mandate to worry about them, but if we don't think this is lasting, we can look through it in any way. If we overshoot for a little while, we might undershoot after that and we'll level out.

Hirst: That was brought in and in reasonably short order, they seem to have ditched it in its entirety. Now, because headline inflation is over 10%, year-on-year core inflation starting to get to the 5, 6% mark, we are getting some very concerned statements out of the ECB saying, “well, yes we were going to look through this, but this is too high. This is too big, and we've got to start acting.” And you know what? I think there's one way in which you can say, well I'm sympathetic to this and that's because there is some anchoring… there's good evidence that consumers, households and to an extent, businesses anchor extraordinarily quickly to spot. It tends to take longer for it to impact longer term measures because they seem to say, well it gets to 2% in the long run anyway. But near term, year out inflation expectations are very, very closely anchored to spot.

Hirst: And as they creep up, if it looks like they're starting to spill over into things like actual wage settlements, you can understand that the ECB would get a little bit worried that you then de-anchor from target completely and they're then chasing the market and chasing inflation back down. So I think that was the point of concern that they got to is they saw that rapid acceleration post-Russia's invasion of Ukraine and the energy crisis that followed. They knew that the cause was the energy prices, but they were willing to suspend their disbelief here and go, "Well it doesn't matter because we are terrified that this is going to be capitalized into wages and then that's going to be capitalized more into prices and it's going to come back through that channel." The thing I would say about it, and I think this is an interesting nuance, is while in the US the way that wage increases have materialized is largely through the churn that we've seen in the US labor market.

Hirst: Elevated quits rates, elevated job to job moves and that's giving people the ability to capture the switcher premium, which you can see in the Atlanta Fed data and that pulls up the aggregate. Europe doesn't really have a dynamic labor market in the same way the UK does, but in most of continental Europe people are more tied to their employers. Plus you have the furlough scheme as the pandemic response which also tied people or kept people employed by the same employer so you didn't have that churn out effect through 2021. So there is, underneath the surface, a little bit more churn and certainly we've seen similar things, like job openings, are elevated relative to the pre-pandemic levels, but we've seen nothing like the furious churn that's delivered wage increases in the US. Much more of Europe's labor market is still unionized, and that union effect means that, actually, the realization of wage pressure is a slower but a longer lived phenomenon.

There is, underneath the surface, a little bit more churn and certainly we've seen similar things, like job openings, are elevated relative to the pre-pandemic levels, but we've seen nothing like the furious churn that's delivered wage increases in the US.

Hirst: So you get these unions going into wage negotiations with employers, this happens over a period of months. The unions say, “we want 10%,” the employers say, “we'll give you two,” back and forth, back and forth. Historically, it's almost always leveled out at something like three or 4% and everyone walks away feeling like they've won something in that. The employers have talked down the extreme ask initially and the workers have talked the employers up a little bit. There was huge concern that this time around, because of elevated inflation, because of the squeeze on real incomes that we're seeing in Europe, that unions would take a very, very hard line, and we've seen numbers like 8% thrown around. And unions do seem to have bargaining power. Labor markets look tight, unemployment levels are very low, below pre-pandemic levels. As I said, job openings are elevated so it's possible that this could have been a real break with the norm.

Hirst: The numbers so far this year, negotiated wage settlements, are at around 4%, and the most interesting thing about this isn't just that they're at 4% now. It’s if you look at how that then transforms into a 2023 number because they've baked these things in not just for one year, but for multiple years there's actually a step down in the wage settlement. So you get 4% this year but then it falls back to 3.5%, the idea being that it looks like even the employees, even the unions think that this inflation is temporary. So I look at that and I don't see a wage price spiral, and in fact what I see is a bit of real wage rigidity, an ability of unions to say, “look, we'll take pain here, but we are not willing to take all the pain. You've got to split this with us, you've got to take some margin pain, pay us out a little bit now, but we are happy to go back to almost the way things were if this resolves down the track.”

Hirst: That doesn't seem like militant unionism, that doesn't seem like a break in the structure of labor bargaining power in Europe and yet if you read people like Isabel Schnabel, a member of the governing council, her view is that we've got an incredibly steep Phillips curve here and we should be really worried about the ramp up of wages. I just don't see it. I don't think that analysis is available in the data.

Beckworth: That's very interesting. So a very different labor market and therefore different wage dynamics story. And even in the US, to the extent wages are contributing, it's a much smaller number than in the headline, in the headline number there's a lot of other things bleeding into that… oil and other energy costs, but over there no good evidence, especially from the unions, that this inflationary spiral is on the way. And the thing is, even the ECB itself… I think you pointed this out and I've read this in some of their speeches, even the ECB says in their statements and their speeches that most of what we're seeing is energy driven, supply side driven. So they acknowledge that, right?

Hirst: And we've already seen energy prices are coming down. You can look at your Bloomberg terminal today and you can see that they've already fallen, so yes we're at much, much higher levels, high enough levels that I am confident that next year we're going to see discretionary consumption baskets get squeezed as more of a share of income is going towards non-discretionary household bills, energy bills. And I think that's baked into the pie now, but what I don't think you see is a year-on-year hiccup in energy prices by this time next year. It looks like there's, in fact, by the middle of next year, we're going to start to see the impacts of energy falling away. So my best guess is that by 2Q next year headline inflation is going to be on a very dramatic downward trend. As the food and energy costs start to roll through some of the high prints of 2022, it'll start to roll off and that will pick up momentum as the year goes on. A now cost estimate puts us at around 3% year-on-year by tail end of next year, and that's if the ECB does effectively nothing from here.

Hirst: My concern is they are looking at spot inflation ramping up now and thinking, well, there's probably no harm in delivering… the market is pricing in effectively another 100 to 125 basis points of hikes from here. So more aggressive than what we have left from the Fed despite them acknowledging this is not domestically caused. We're seeing financial conditions in the Eurozone tighten already. We're seeing the impacts of that, I think, spilling over into consumer confidence which in some case are worse than we saw during the financial crisis. Yes, there is enough reason right now to say, "well, look households are in a reasonably good position to weather a bit of a downturn here. Actually, the energy crisis is not as bad as feared, the downturn might not be too bad," but the ECB seems determined to make it just a little bit worse than it needs to be despite being able to see the decline in inflation through the second half of next year.

Hirst: For me, and I don't want to overstress this point too much, but it does seem to be an abandoning of their attachment to their medium-term mandate and a bit of an abdication of duty here to the welfare line item, right? It's like it's going to make people's lives worse next year, not because it believes that structural inflation pressures have picked up, but simply because optically and reputationally, it is better for them to look like they did the thing that brought inflation down rather than acknowledging this leg of inflation has been almost entirely out of their hands. They could have done nothing on the way up and basically they could do nothing on the way down, it's going to be someone else's problem.

We're seeing financial conditions in the Eurozone tighten already. We're seeing the impacts of that, I think, spilling over into consumer confidence which in some case are worse than we saw during the financial crisis... There is enough reason right now to say, "well, look households are in a reasonably good position to weather a bit of a downturn here. Actually, the energy crisis is not as bad as feared, the downturn might not be too bad," but the ECB seems determined to make it just a little bit worse than it needs to be despite being able to see the decline in inflation through the second half of next year.

Beckworth: Well, that's a great take. I was reading on their blog, the ECB has a blog and in August some of their economists wrote an article, *The ECB's New Inflation Target One Year On.* So you talked about this new framework they adopted, and I got a bit of whiplash reading this article. It's like a rollercoaster ride because they begin by talking about the need for this new symmetric framework, which is great. They're not going to be viewing 2% of the ceiling, it's actually going to be symmetric and they talk about the need for it, the same reason the Fed adopted its new framework. They were worried about hitting the zero lower bound, the lower the equilibrium rates have fallen, and they were worried, really worried about being stuck in low, low inflation, low interest rates.

Beckworth: So they have several paragraphs and then they jump to this year, today's challenge, keeping inflation expectations anchored at 2%. So they go from one, worrying about zero lower bound to now we got to worry about getting inflation back down. And to be fair to them, their thinking, again, is they see the expectation component becoming important, unanchoring of future inflation expectations. They acknowledge supply side factors are at work now, but the inflation expectations are the big concern they have coming off. In your view though, you've alluded to they want to look good, but do you think some of them genuinely believe and are worried about inflation expectations becoming unanchored? It's just in their blood, they're central bankers and they can't think differently, they can't think like you Tomas. I mean, maybe that's part of the problem.

The Inflation Expectations Conundrum

Hirst: I believe that they are arguing in earnest, I believe that they're arguing in error and I think that is the way that we need to think about this. And it makes sense from their seat because they have asymmetric risk around this, right? If inflation undershoots ah, well, that's not really the biggest problem for them. If inflation persistently overshoots, this is very dramatic for them. They have lots of people on the governing council who continue to be extremely inflation averse. It does of course have welfare implications, especially if it's externally driven and this isn't being realized in wages and they do worry that ultimately if you get de-anchored expectations that they would have to create a bigger welfare hit somewhere down the road, so course correct. Again, what I would say is the evidence that we have is that inflation expectations, be it market measures that they're up a little bit, but like two, two and a half range. If you had a symmetric mandate you wouldn't be really stressing about that. Headline at 10, five year at two and a half, you're thinking we're probably doing a good job here keeping this all in some kind of check.

Hirst: And if you look at surveys of professional forecasters, again, the long-term inflation expectations have ticked up a little bit, but only a little bit, and only around the margins. And all they're doing is re-anchoring, right? They're looking at what you've just seen and saying well, it may be that the risk going ahead is a little more balanced than we thought it was and so you stretch it a little bit higher. One of the things that has frustrated me I think most about the ECB’s arguments though is the wild inconsistency of them. So we've had the expectations argument and then you present the evidence to go well, expectations from what we can see are reasonably well anchored. And the wage outturns that you're really worried about which is the union point I was mentioning actually look really well behaved so maybe that's not the biggest issue now.

Hirst: Aha, Isabel Schnabel, well, what you haven't thought about is the structural factors underpinning inflation. So de-globalization, the green investment boom we've got to undergo, demographics, all of which have been changed a little bit by the pandemic. So on the deglobalization front, we have seen geopolitics in Europe change. There is no doubt that the relationship with Russia going forward is going to be very, very different to what we've had in the past. Access to cheap Russian gas is going to be much more politically fraught for the vast majority of Eurozone countries. It is therefore possible that there is a period of transition here, and that in that period of transition we have higher variance in inflation. Certainly, in energy driven inflation which leads onto the green investment line, right?

Hirst: During that period there will be an elevated spend on bringing online faster, alternative sources of energy including green energy and that's baked into the NextGen EU package as well. What I would say is again, in the near term it is possible that creates more volatility in headline inflation measures which will be baked into some expectations, right? But it's not clear over the medium term which sign this puts on inflation, because it's perfectly possible and it now in fact looks quite probable if you look at how quickly Europe seems to have adapted to the loss of Russian gas. We've underestimated what can be done, and if we can get energy imports at scale locked in at predictable prices and bring green investment on and faster than we thought, it's possible over the medium term that it's actually disinflationary, structurally disinflationary. Energy prices are no longer set by the marginal barrel of oil, it's actually set by how much wind and solar and to what extent tidal energy can be harnessed.

Hirst: That seems perfectly plausible to me that that's an outcome here so we don't know the sign there. On the demographics, there's been some interesting stuff with tales of long COVID or early retirements we've had some evidence of as well perhaps due to elevated savings levels that we saw over the pandemic. Again, very plausible, but I don't think those have dramatically shifted in the two year period that we've seen. I think, to blame structural forces for what we can clearly see is a short term energy shock rather begs the question, right? These things are worth discussing and worth monitoring, they do not set the near term terminal rate. That is just an unreasonable proposition, and it's certainly unreasonable to suggest we've got greater insight in the last 18 months that oh, it means inflation's going to be 4% unless we have rates at three. It doesn't make any sense to me. So this narrative drift that we've seen for people just desperate to hang something on, we are raising rates and we're going to justify it one way or another and we're just going to throw mud at the wall and see what sticks is incredibly frustrating to me.

I think, to blame structural forces for what we can clearly see is a short term energy shock rather begs the question...These things are worth discussing and worth monitoring, they do not set the near term terminal rate. That is just an unreasonable proposition, and it's certainly unreasonable to suggest we've got greater insight in the last 18 months that...inflation's going to be 4% unless we have rates at three. It doesn't make any sense to me.

Beckworth: Well put. It seems like you explain that energy and supply side is the key driver right now, and then they point to inflation expectations and you say, well, those actually are pretty anchored right now and then they point to something even beyond that. So they're taking a forecast beyond the forecast looking at potential developments down the road that could have these, potentially, inflationary or as you say disinflationary forces as well.

Hirst: Yeah, have you considered the AI robot army that's coming down the track in 60 years? No, I haven't considered that.

Beckworth: Very deflationary.

Hirst: Yeah or so I would guess.

Beckworth: Yeah, no doubt. Well, let me follow up, Tomas, with an excerpt from an interview with Philip Lane. He's the chief economist of the executive board of the ECB, and get your response to his response to the question. So this interviewer asked him the following question, "For monetary policy, which is a bigger risk, doing too much or doing too little?" This is the question posed to him and he says, "It is important to recognize the worst case scenario is one where inflation remains too high for too long. History teaches us that it is very costly to get rid of entrenched inflation. We need to avoid that by making sure inflation goes back to 2% in a timely manner." Then the interviewer goes on and asks, "Can you specify what you mean when you say you want to get inflation back to 2% in a 'timely manner'? In what ways does the meaning of this expression differ from in the medium term?"

Beckworth: And this is Philip Lane's answer, "This is a very important point. The ECB has always said that we have a medium term approach, but without providing a precise definition. The medium term can be longer if the deviation of inflation is not too great, but should be shorter if we have a big inflation gap to fix. This is the case at the moment so we use the expression 'in a timely manner' to not tie us to any particular year or period of time but to essentially signal that we want to get inflation back to 2% at an appropriate speed and not to take too long. So it's not satisfactory to say inflation will be at 2% many years from now, we have to make sure that inflation is back to 2% within a reasonable time horizon and the governing council will decide exactly what that will be." Thoughts?

Medium Term Inflation and the ECB’s Two Percent Target

Hirst: I'm really sympathetic. I think that the framing intuitively makes a lot of sense to me, and it follows the expectations line of thinking. And what it says is the larger the shift above target and the longer that lasts, the more aggressive you have to be in order to convince people that you are taking this seriously. And so I think it's a very good argument for why, middle of this year, even though they knew this was an energy driven phenomena they started raising rates. I think that makes sense to me. And they were saying we're going to continue to raise rates until inflation is on a downwards trajectory. I am quite comfortable with the frame. I think where we need to step in and move from theory to practicalities is how much rope does the ECB really have credibly to promise to do that? One way we can think about this, and I think I've discussed it in fact with you before David, is to think about the nasty fiscal arithmetic for a country like Italy.

Hirst: Now, before I go down this route I do acknowledge that Italy has turned out its debt very successfully, and actually to realize higher interest rates does take inter-debt interest cost is a multi-year phenomenon. But let's just play devil's advocate and imagine that what happens here is the ECB wants to chase our rates to 2% and hold them there. So they get to 2%. Well, let's assume that the market thinks they're going to hold them there indefinitely and assume a modest term premia of say, I don't know, 50 basis points so you get a 10 year bunt of two and a half. Well, the ECB thinks or has historically thought that a reasonable yield spread premium on Italian debt over German debt is somewhere in the region of 150 basis points. So that's a handicap of let's say 150 to 200 basis points there. So you are already talking about four, four and a half, that doesn't sound too much, but then look at Italian nominal growth expectations. Best case scenario for Italy you're probably looking at something with a three handle and a lower three handle, so 3% give or take.

Hirst: I'm really happy to debate how we split that between our GDP and inflation, but for the sake of this argument let's just half and half it. The problem is, as your interest costs creep up to four and a half, can you sustain that with 3% nominal growth domestically? I mean, it's hard, right? That's a tough bit of fiscal arithmetic. And if the market thinks you can't sustain it, does the market just sit there and go, “ah, this is fine. We'll just wait for you to actually struggle before doing anything about this?” Or does it do what it has done with BTPs in recent history and start selling really, really aggressively? Either forcing the ECB to step in to resolve the market or as we were saying before forcing some sort of collective mechanism to resolve it, or allowing Italy to go to the wall, somewhat lower probability. My point is it's not credible for them to say, “oh, we're going to keep ramping up rates and not worry about the dynamics here.” At some point they ramp up rates, but then the ECB has to step in and stop that from having any impact because it's causing a problem on the fiscal side.

Hirst: Another way we can see this problem is the heterogeneous nature of the mortgage market across the Eurozone. So overall it's roughly 30% of households own properties with a mortgage, but that number differs hugely country to country. So it's roughly 30% in say Germany, but it's upwards I think of 60% in the Netherlands and in Italy it's only 18%. And then within that, the amount of mortgages that are on fixed or floating rates, so variable rates, right, I think is the equivalent, differs wildly, and the term structure of the fixed rates differ wildly. So in Spain for instance around a quarter of all mortgages outstanding are floating rates so the interest costs on those will move in step with changes in the base rate. Whereas in Germany your typical mortgage is fixed for 10 plus years from the current date, so it's much, much harder for you to impact domestic conditions through the housing channel in Germany than it is in Spain.

Hirst: And in Ireland for example, almost the entire term structure of their mortgage market is floating rate or zero to five years, so they're going to feel the impact of these rate moves so much earlier than other parts. So what do you do in that situation? You've promised to keep 2% inflation overall, but the way you're achieving that is crushing individual housing markets in parts of your union while other parts of the union barely even feel any impact. So that's another channel through which, really, is it credible that they're going to keep raising rates to a point where you knock the Irish housing market over or you knock the Spanish housing market over? I don't think that's credible. So, I think the wisdom of large increments, raising rates at large increments in the Eurozone, simply isn't there for me. Certainly, from this point where we are, very, very close to a reasonable expectation of where equilibrium long term rates might be.

Hirst: And I think they are starting to play a game of dice here with the market in a very unhelpful way. Instead of saying, “look, we're at this level where we will continue to raise rates, but in 25 basis points increments in a slow but steady pace until we see inflation come down which we all strongly suspect will happen early 2023 anyway.” They're saying, “no, we're going to keep hitting you with 50 basis points and maybe 50 again and ramp up so your terminal rate is chased up.” All that does to my mind is create a snap up, snap down type of rate scenario which is the least helpful from both a domestic growth perspective and in a domestic planning perspective. What is a representative household supposed to do if the central bank is telling them we're going to keep beating you until things break, but then don't worry in a year's time rates might be all the way back down to where they were 18 months ago? It just feels to me like that is a poor way of communicating a transmission mechanism, a poor way of actually delivering the tightening you want to do rather than saying we are committed to delivering 2% but we're going to do it in a way that doesn't force an asymmetric transmission mechanism across the region.

It just feels to me like that is a poor way of communicating a transmission mechanism, a poor way of actually delivering the tightening you want to do rather than saying we are committed to delivering 2% but we're going to do it in a way that doesn't force an asymmetric transmission mechanism across the region.

Beckworth: Okay. So in some countries in Europe the transmission mechanism for monetary policy is relatively quick if they have these variable rate short term mortgages, whereas in the US we got 30 year fixed rate mortgages, it takes a while sometimes. If housing's a key transmission channel, then it's going to take a little bit longer for the effect to be felt which is interesting in its own right because as you know, the Fed's monetary policy gets transmitted throughout the rest of the world. And what's good for the US economy is certainly not necessarily good for Europe and other parts of the world, so we have this this problem again where the Fed sets policy for the US but unfortunately affects the rest of the world. And the same thing for the ECB, effectively they're setting this rate that has different repercussions in different parts of the Eurozone.

Hirst: We haven't even talked about the FX channel yet which I've been leaving to one side.

Beckworth: Let's do that, let's talk about that channel because I also have heard that as part of the motivation for what the ECB's doing. It's worried about the dollar being really strong, and the dollar's come down a little bit, but the dollar is still up quite a bit this year and they're worried about the Euro being really low and that's going to import inflation. So walk us through that argument and your critique of it.

The FX Story and ECB Recommendations

Hirst: So the argument is effectively that while central banks don't like to talk about FX directly, they don't like the idea of having a currency war on their shoulders, there's a tolerance bound, effectively. And if the FX rate shifts through the tolerance bound, which they can set pretty wide for most developed markets because these are such liquid markets and they're moving all the time. They don't need to worry about a couple of days of movement if it stays shifting in one direction. So as that rate differential between the Fed and the ECB grew and the dollar started to strengthen very, very aggressively, there was a growing concern that domestic producers in Europe that were having to import dollar priced commodities were having to pay up and that in that effort they would then pass those costs on to consumers to bear at least some of the costs, so it's not all margin squeeze. I think that is a reasonable critique of a very short term phenomenon. I mean, I guess to the extent that that was happening they could be a little bit worried about it. It's a very good way of soaking up whatever excess savings might have been left.

Hirst: It seems to me difficult to imagine that dynamic, holding in a situation where domestic demand is weakening substantially and unemployment is rising. Say, if the outlook for next year is correct and we get a recession, albeit a mild one, it becomes much harder it would seem to me to be passing on FX in that way. It looks more likely to just be a margin squeeze story, which isn't great and not necessarily something that is obviously counteracted effectively through ramping up rates. But it's clear that at some point what they were worried about is that your peak print here would've been even higher had they not started to move rates closer into line with the Fed and narrow that gap, prop up the Euro to a certain degree, and stop their margin squeeze being as aggressive as early. I guess the way I think about it is it's probably a way of sharing the pain out a little bit across different cohorts so it's not all importers, the domestic borrowers in effect have taken some the pain for this as well.

Hirst: So it's not complete anathema to me that central banks would be aware of the FX channel and that it would weigh a little bit in their thinking, but it does seem to me that if that is the sole rationale it's a very weak one to benchmark against on an ongoing basis. And as I say, I think the ECB's probably done enough already to get the market to stop continuing to price them out, and if you look at where the market is starting to price the Fed now, there is some hope that they get pretty close early next year to terminal and may even start to lower rates, if not next year then in early 2024, and there should be a natural drift down thereafter as the Fed moves away from restricted territory.

I think the ECB's probably done enough already to get the market to stop continuing to price them out, and if you look at where the market is starting to price the Fed now, there is some hope that they get pretty close early next year to terminal and may even start to lower rates, if not next year then in early 2024, and there should be a natural drift down thereafter as the Fed moves away from restricted territory.

Beckworth: Alright. Well, Tomas, in the time we have left, any final parting words to the ECB, to the governing council? If you could give a recommendation to them, if you could recommend suggestions for the next framework review, what would you leave with them?

Hirst: So I think they could definitely do worse than taking a look at your framework on NGDP. I think that would help to give them a perspective with where they sit vis-a-vis the US, and help, I think, to discipline expectations going forward. I think my overall takeaway over the last few months has been that they really just need to think about gradualism now, that most of the real shock is behind us and inflation is just a lag measure of that shock. We can see already that commodity prices are coming down. We can see that to the extent that we should have been worried about wage price spirals. Thankfully, this hasn't turned up in the data in any size so we can start to look instead at the growth trade off through next year and the welfare trade off from over aggressive policy now. And I think that the ECB could step off a little bit earlier than the market is currently pricing, basically, and do so in a way that would be very consistent with bringing inflation back down to target. In fact it's likely in my view to be slightly under target as we move into 2024.

Beckworth: Okay. With that our time is up. Our guest today has been Tomas Hirst. Tomas, thank you so much for coming on the show.

Hirst: Thank you. It's been a pleasure.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past present and future...