Darkening sentiment is a ‘major concern’, says ECB chief economist – POLITICO

FRANKFURT — The latest decline in economic sentiment is a major concern, suggesting the eurozone economy could take a big hit from Russia’s war on Ukraine, according to European Central Bank chief economist Phillip Lane.

In an interview with POLITICO on Monday, Lane pointed to “quite large and substantial” drops in sentiment indices for both consumers and businesses, calling them a “major concern” for ECB policymakers. Last week, eurozone consumer sentiment posted the second-largest decline on record, while business output expectations slumped.

Front and center is runaway inflation, which Lane summed up bluntly. “Europe may have to get used to higher prices,” he said, but added that most of the inflation “will subside.”

“The momentum – where each month inflation is higher than the previous month – we think it’s going to come down,” he said. “Inflation will come down later this year and be much lower next year and the year after compared to this year.”

If the deteriorating growth outlook threatens to push inflation below target, it could force the ECB to declare that it is ready to change course on its plans to end its massive purchases of ‘obligations. Lane reiterated that stance on Monday, saying the ECB would react flexibly if the war wreaked even greater havoc on the economy than expected.

The fact that eurozone inflation has almost reached 6%, nearly three times the ECB’s target, prompted the ECB’s Governing Council earlier this year to accelerate its exit from asset purchases in large scale. At the time, the ECB also changed its policy guidance to indicate that it would raise interest rates “some time after” the end of asset purchases, rather than soon after – a signal that it would not not rush to raise rates.

Lane also touched on the latest projections from ECB staff, which called for the economy to grow 3.7% and inflation to average 5.1% this year. He declined to say whether the latest data renders that forecast obsolete. However, he noted that some indices point to upside risk to energy prices while others point to downside risks to growth.

Any revision to the growth and inflation outlook at the ECB’s June meeting would require “a significant drop in the medium-term inflation outlook” for the ECB to continue its bond purchases beyond the third quarter of this year, added Lane.

Whether the central bank’s first interest rate hike in more than a decade would follow later this year depends on incoming data, he said.

“We’re trying to be as clear as possible that monetary policy will be data-driven,” Lane said. “There are scenarios where it would be appropriate to start normalizing interest rates later this year. And then, of course, there are scenarios where it might be appropriate to move later.”

Lane pointed to a high level of uncertainty surrounding the economic outlook given the war, the recovery from the pandemic shock and the latest twists of the pandemic – such as China’s call to impose a strict lockdown on Shanghai.

“Under these conditions, trying to give timing guidance is not helpful,” he said. “The commitment is that we will ensure that our monetary policy responses are the right way to ensure that over the medium term inflation stabilizes at 2%.”

Too pink?

Lane defended recent ECB staff projections, which include alternative scenarios that assume an immediate boycott of Russian gas and oil. These projections had been criticized for being far too optimistic. Even in the most severe scenario, the ECB still sees the euro zone growing by 2.3% this year and next.

The ECB’s forecast stands in stark contrast to those of German private sector and government economists, who insist that an immediate ban on oil and gas would push Europe into the next recession.

Indeed, German Chancellor Olaf Scholz on Sunday night lashed out at economists who suggested the eurozone economy could withstand an immediate boycott of oil and gas. They are not only “wrong” but “irresponsible” for making such suggestions based on “a mathematical model which, in the end, does not really work”, he told German television.

Lane tried to distance himself from the debate.

“Let’s be clear that these were two scenarios, but they were explicitly not intended to be extreme scenarios,” Lane said of ECB staff adverse and severe scenarios. The severe scenario assumes that the interruption in energy supplies is only temporary and that Europe will have found an alternative source of supply towards the end of the year.

“If you impose a longer period of interruption in energy supplies, then you will have a greater drop in GDP,” he said.

Lane also pointed out that the euro zone was still emerging from the pandemic-induced recession, so the “substantial” hit of the war on the economy – which is assumed in all scenarios – is partially offset by a strong recovery after the recent low as consumers spend on late purchases.

“The bigger issue…is that we’ve set out a flexible, optional monetary policy framework, which is basically expressly designed to be able to respond to whatever happens in terms of the medium-term outlook,” Lane said.

Tax actors

Lane also weighed in on the proposed reform of the Stability and Growth Pact, the fiscal architecture that underpins European economic governance that appears to be tweaked amid calls for more flexibility from countries like France and Italy.

Lane noted the fundamental importance of spending rules calling for budget deficits below 3% of GDP. At the same time, “you still need a debt anchor,” he added. “Highly indebted countries need to see those debt ratios come down.”

While current rules require heavily indebted countries to gradually reduce debt by 5% to eventually reach a 60% to GDP ratio, Lane suggests a ‘softer’ reduction of 3% rather than the current rate of 0.5% .

“The pandemic has shown the value of joint European funding, whether it’s SURE or Next Generation EU,” he says, referring to the Commission’s historic recovery programs during the pandemic. “We are facing very significant carbon challenges. The climate, in particular, but you can also think of other dimensions of that.”

“[Any] the response to carbon shocks having forms of carbon finance, either of the SURE dimension or of the next generation of the EU, should be part of the broader budgetary recipe for Europe,” he added .

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