With inflation in Europe on the way back down and after a rate cut in June, the ECB just announced that it will keep rates stable for now and that anything can happen in September.

So, does this mean that higher interest rates are here to stay? Or could we soon return to the ultra low inflation and interest rates that we were used to before the pandemic?

To find out, I sat down with the ECB’s chief economist —Philip Lane— for a long conversation about how the ECB looks back at the past inflation spike, its own response, whether or not higher interest rates today are causing too much collateral damage, for example by holding back investments in new energy sources or new houses, and finally, about what we can expect from inflation and interest rates for the future.

Joeri Schasfoort (JS) Philip, thank you so much for talking to us all about interest rates and inflation in the Eurozone, a topic that has perhaps been on the minds a little bit too much in the last couple of years. The goal of this conversation is really to talk about what we can expect to happen next with interest rates and inflation, with the context being that the ECB just announced that they will keep rates steady for the moment. But to get here, I just figured maybe you can explain to us all a little bit sort of what happened, starting with if we go all the back the way back to the pandemic, where we have seen inflation spike in an unprecedented way for at least a younger audience like this, this was unprecedented, like, what were some of the lessons learned there? Or maybe actually, we can start with looking back, what was behind that inflation spike.

Philip Lane (PL) Thank you for the invitation. It’s a pleasure to have this opportunity. Maybe I’ll start five years ago, in summer 2019 when I joined ECB. So when I joined ECB, we we were in the middle of a long period where inflation was around 1%. Our inflation target is 2%. And in response to that low inflation situation, we had adopted policies that were accommodative. In fact, in September 2019, we moved the policy rate from minus 0.4 to minus 0.5. So that may sound strange to some of your viewers, but we had negative interest rates.

JS Trying to encourage inflation?

PL (01:52) Right. And on top of that, because there’s a limit to how negative you can go, we were also engaged in a big bond purchase program, which we restarted in September 2019. So before the pandemic, a few months before the pandemic, all the debate, all the view was, this is going to be with us for a long time, a low inflation problem. Then at the first of the pandemic in 2020 in fact, inflation fell. It went a little bit negative in late 2020. So in 2020 initially the focus of the pandemic was.. There was a really big drop in activity, the drop in spending, then in fact there was a drop in inflation.

JS And is there then the sort of the simple economic model that that the bank had in mind, that inflation is primarily caused by an economy that is overheating, and so when this demand fell even lower, inflation becomes lower.

PL I think it’s important, and maybe it’s good to take it on at the start of this conversation. I think the way to think about is there’s two parts to inflation. One is the anchor. What is the anchor of the system? And then around that anchor, inflation will fluctuate with either demand or supply shocks. So indeed, in the first year of the pandemic, it’s probably fair to say that demand was very low. People could not leave their houses. There was a big pullback. Of course, there was supply effects as well, but let’s say in 2020 the big effect was low demand. In 2021, at the very end of 2020, the very good news arrived that the vaccines had been discovered. And in the course of 2021 we had this kind of waves of recovery in the global economy, but also waves around the world at different times of new lockdown periods, because of new [COVID] variants, we all remember this period. So in 2021 what we had was a partial recovery in demand, with supply being constrained, especially factories around the world having shutdowns. So the initial rise in inflation, I think in 2021, I think it was commonly referred to at the time, and I think it still remains accurate: it reflected bottlenecks. There was a recovering demand in the global economy, but the ability to supply goods was limited, and in that mismatch, prices went up.

JS And a counter that was often heard at the time was because, I think at that time, there had already been a lot of stimulus, because, like you said, policymakers were afraid of deflation, right? So wasn’t there also a narrative at the time like “hey, look, the money supply exploded”. Why do we look back at this and think, hey, actually, it was the supply bottlenecks that were the biggest factor, and not this stimulus. Because I think everybody can at least agree that all of this played some role, but we’re talking about what’s really important?

PL (05:23) Yes, I think, of course, that this is a natural question to raise, given the fact that various indicators, for example, the money supply did go up. But what I would say is, of course it varies around the world, but from a European perspective, I think probably a better description of both fiscal policy and monetary policy in 2020 and 2021 was stabilization. It was not trying to stimulate the economy, because, indeed, the supply capacity was limited. There was not much you could do. But there was definitely a desire to make sure that incomes were stable. So even though many firms were only working on a partial basis, I think it would have made the pandemic situation a lot worse if we had delivered austere policies. That would mean income levels dropped in 2021. So I think crucially, from a European perspective, we did not see overall spending in, for example, 2021 go above the pre-pandemic level. Spending was still low compared to the pre-pandemic level. I think this is fundamental. The increase in the money supply, a lot of that was firms who needed to take on short term loans to pay their wage bill, for example. So it wasn’t stimulus in terms of expanding the economy. It was keeping the doors open, if you like, the factory doors open.

JS So, a lot of the money supply increase…. Because I think a popular narrative is like, if the money supply increases, there’s money printing by the government and central banks, sort of, that’s sort of the simplified view there. But are you saying that a lot of that actually came from private firms taking up loans with private banks, of course, enabled by very low interest rates, and that increased the money supply, right?

PL If you look at essentially the overall creation of money, indeed, there was a lot of credit provided by banks to corporates. We also created money directly. For example, we did have a big bond purchasing programme. So at that time, you know, I think governments ran very large deficits. I think if we wanted to make sure that households, workers, firms maintained, if you like, income during this period, then the government had to run large deficits. And in order to make sure that we could also maintain stable financing conditions, there was a big special bond purchasing during that time. So there was money being created directly by the Central Bank, as well as the indirect money, the commercial money created by banks. But critically, for the question you raise, the overall level of spending remained well below the pre-pandemic level. And I think it’s very important to recognize… maybe behind everything is… It was 100 years since the last global pandemic. The economic world as well as the public health world, many worlds studied very hard the nature of the pandemic, what was needed in terms of policy. So maybe to kind of summarize on this, I think the policies in 2020 and 2021, which were extraordinary, were basically just matching the extraordinary challenges of the pandemic. Coming back to the inflation issue, maybe one fairly basic way to think about it is in 2021, if it had been a money created inflation, that classic story basically means people would go out, they had too much money, and therefore they’d say, Okay, let’s spend. And then you would see the demand for everything go up, prices for everything go up. That’s not what happened. What happened was basically a large increase in the price of goods, because even [inaudible] you could still order a new exercise bike and other things. And also an increase in the price of energy. The services sector was still very restricted. So I would say it looked more like a supply shock, in the sense of the prices of those goods where supply was scarce rose quickly. And the reason why we say it’s a bottleneck is at that time, which I of course remember very vividly, you could look forward and say, “Okay, this bottleneck is not going to last forever”. The vaccines are now being rolled out. As the vaccines get rolled out, the economy will normalize and all of these factories that are currently shut down will reopen, and the ability of the economy to supply what is demanded will improve. In other words, a bottleneck by its nature, means there’s a spike in prices, but then later on, that reverses. And in fact, we have seen since late 22 onwards, a reversal in a lot of those price pressures.

JS Yeah, okay, because that’s, I think, part of the criticism. Also sometimes, like, okay, prices have gone up, but they never go down. But actually, for a lot of these goods, like bikes, indeed, I remember during the pandemic, they have come back down.

PL (11:23) Well, I mean, I think to some extent you might see it in some goods. I’m not going to exaggerate the amount they’ve come back down, because then in the full dynamic of the economy, there’s a catch up of other costs, including wages and so on. But what has come down is energy prices. So from the peak, which was October 22. In summer 23 the energy prices in Europe fell by 14% so again, not just zero inflation, deflation of 14% over a number of months, and that has played a big role in what’s happened. Yeah, so let me mention… because we’ve talked about the pandemic there….

JS Before you go on, because I think you’re moving to the next subject. If I can sort of summarize there, if I understand it from you correctly, is that you work on a sort of data based, like, evidence based approach, like looking back. Okay, maybe there was some evidence, like the money supply increasing that initially pointed in, sort of for some points in a money printing kind of story, but that then we would not have seen, or then we would have seen that spending would have gone out of control. We have not seen that. And then we would have seen a general increase in prices, rather than just focused on a few sectors. And so based on all of this evidence, we can maybe conclude, like the most reasonable story about inflation, looking back before the Ukraine invasion, at least, where the supply bottlenecks?

PL Right. And again, you come to the same point I was about to make, which is essentially there were two different inflation episodes, but they came one right after another. So in 2021 I think the bottleneck description gets you most of the way. In 2022, we essentially had the Russian unjustified invasion Ukraine in late February. But of course, there were kind of debates about about whether it would happen from late 21 onwards, with the kind of position of troops and so on. Yeah, and I think it’s very mechanical. What happened is essentially mostly in the gas market. There was this gigantic shock to the gas market where the Russian supply was now not available, and that had a very large impact. But let me emphasize again, at more or less in the exact same weeks and months, we had the final reopening of the European economy. Because if you remember, in late 21, December 21 through maybe February 22, there was a kind of renewed lockdown of many parts of Europe because of the Omicron variant. And so essentially, in February, March 22 at the same time, we had the Russian invasion of Ukraine, which was very destabilizing for the energy system. But we also had the reopening of the European economy, and for many people, the first time they could really do, for example, tourism or business travel, was Spring, Summer 22. So in the exact same months, we had this very negative supply shock from the war. But we also had, if you like, the good news of the reopening of, for example, the tourist sector in Europe. And so it is really in parallel, we had the big energy shock, but there’s also a contribution from this pandemic reopening - this phrase we use - because of tourism, [because] people very quickly wanted to travel, go out to restaurants and so on. But of course, that sector’s supply capacity had gone down. Many people had left because there was no work for them for two years and had left the sector. Many airlines that cut back on their schedule and so on. So there was, if you like, a perfect storm of inflation in Spring, Summer 22.

JS Yeah. And then, okay, so that is also supply side issue largely, right? But why then did the ECB raise interest rates? Because that is only affecting demand, right?

PL (15:50) This is where, again, you have to learn the lessons of history. And for example, many people look back to the 1970s which is what happens when you have these really big, extraordinary and as you said at the start, very much from the point of view of many people below a certain age, unprecedented increase in inflation. Even if the origin is supply, it’s very natural that essentially, two factors would then create a next stage, a second stage of this process. One is that firms were seeing their cost increase. Across the economy, firms use a lot of energy, for example, and these all sorts of other inputs which have gone up in price. So even if these firms are not seeing an increase in demand, in order to avoid making losses and to survive, they have to raise prices. On top of that, workers… How wages are set is quite slow. So initially, that very large increase in inflation was not matched by an increase in wages, and so people suffered a very large decline in their living standards. But over time, it could be expected that wages would have to rise to compensate for those increasing prices. So monetary policy comes in to make sure that that second stage, does take place, but that it takes place in a way that people understand will come to an end. So what we say is there’ll be a timely return of inflation to 2%. So not that inflation would go from 10.6% in October 22 to 2% overnight. It was inescapable there would be a step second stage of wage and price adjustment, but to make sure that that did not become the new norm. What happened in the 1970s is that more or less it became the new norm. People got used to prices rising five, seven, 10% a year. So we had to make sure, through raising interest rates, that that process would come back fairly quickly, over a couple of years, back to the 2% target.

JS So then the central bank is going to the sort of final step in thinking about inflation. We’ve talked about supply and demand before, but now we’re talking about expectations, which where the idea, I think, is that they can be self-fulfilling in a way that people expect inflation, they’ll raise prices, and then other people will raise prices as well. And that can happen, you know, almost independently from supply and demand. I see it right?

PL Usually it needs a trigger, and so the shocks were the trigger. And that’s why I said at the start, there’s really two factors to think about inflation. One is the anchor, and then around that anchor, you can have the supply and demand shocks.

JS And the anchor that’s the anchor for expectations, which hopefully is the 2% target that the central bank says, I think, but also often just what happens in history.

PL Yeah. So I think this is matters in both directions. Before the pandemic, we had concerns that inflation expectations were drifting down. They were becoming more like one and a half or one not two. And after the pandemic, there was very natural reason, because, historically, this has happened before, that if people see inflation way above 2% they can question, why should I believe inflation is going to be 2% two years from now unless I see the central bank delivering policies that are going to make sure it happens. And the central bank’s [??] monetary policy is basically providing that anchor. What is the alternative? The alternative to an anchor is what we call de-anchoring, that the anchor loses its grip, and then it can get reset. It could get reset. We’ve had hyperinflations around the world. We’ve had other countries settle on inflation rates of 10 or 15 or six or eight, pick any number you like. But for us, we were, you know, convinced that it’s very important to make sure that the target of 2%…

JS To avoid sort of the Turkey scenario?

PL (20:50) Well, that’s one example which, of course… Inflation in Turkey has been quite high and, as you say, extremely volatile, and that tends to go together. High average inflation and high volatility tends to go together. So clearly, it’s very important to make sure that inflation comes back to 2%. And again, if we fast forward a little bit in our meeting last week, we kind of, if you like, reaffirmed our projection for the future, which is essentially: inflation is now around 2.5% and we will be back to 2% in the second half of next year. So there’s another year where inflation is a little bit too high, but that’s if you like, the ongoing second stage, which, again, as I said, it’s inescapable that second stage, but we need to make sure it doesn’t go on too long. And in that second stage of catch up, where wages and prices are catching up, that it basically is a model [modern?] process.

JS I do think that’s a very interesting answer, actually, because I don’t think it’s thought about enough often that you’re saying, “Hey, we know that maybe it’s been a little bit unfair that prices of goods, for example, and energy, have shot up, but wages have not caught up”. Right? Or maybe, if you go back a little bit to the pandemic supply bottlenecks: there was the issue of profits. There was a big debate that profits exploded for a lot of companies. And so I think when a lot of central banks started raising interest rates, the counter narrative was sort of maybe this is unfair, because wages need to catch up, right? I thought that was interesting that you mentioned, like, we’re aware of this, and this is if we, this is why we didn’t maybe raise interest rates like they did in the 1980s with a Volcker shock at the FED or something like that…. Maybe, you know, if you didn’t take it into kind [?!], would have maybe taken it to 8% or something.

PL I think what’s important is… What would have happened if wages did not grow? Then, I think, we’d have a very severe recession, because with people having… We’ve seen it that people have had a lot less income, which means lower consumption, means lower growth rate in the economy. So it’s important that wages do not remain so far behind prices. So it’s necessary and inescapable that wages have to adjust, but there has to be, if you like, an orderly, gradual process. It doesn’t make sense to have it instantaneously. But equally, it doesn’t make sense to go too slowly. But the context, so whether it’s employers or unions or individual workers. The context of how this process should work, has to be anchored in the understanding that over time, wages need to catch up, but equally, they cannot…. There cannot be a situation where we get in to a cycle where the wage increase is too high, prices have to be reset too high, then the next round of wages… That’s the famous wage-price spiral, and we haven’t seen this.

JS Yeah.

PL (24:38) But again, it goes back to, I think, the context where, throughout this whole period, there has been a high degree of confidence, whether in our surveys of households, of firms, our surveys of financial market participants and so on, that essentially there were some questions about how quickly it would take place, but essentially there was a collective confidence that inflation would come back to 2% within a reasonable time period.

JS Yeah. And if we go to the rate hikes, how much do you think we can say that inflation has dropped because of these rate hikes? And how much do you think we can say it dropped because of the factors you mentioned before that were temporary, or we might even say transitory, if we want to.

PL I think there’s different ways to think about that. So one, I think it’s important that interest rates went up to avoid, if you like, what I would call a pro-cyclical dynamic. If monetary policy had not seen an increase in rates, we could have seen the following situation. Remember, initially, not only was the interest rate low, our policy rate was negative. So what happens if you can borrow money at a very low rate and you’re confident inflation is going to be high for an extended period? That’s what we call a very negative real interest rate. So the inflation adjusted interest rate is very low.

JS Yeah.

PL So you can imagine, in that situation, if people believed that situation was going to last, there would be a lot of incentives to borrow money, to spend quickly. Because, you know, it sounds like money is… you’re being paid, if you like, to borrow in a real sense. This is often called the Taylor principle, that basically the interest rate has to rise more than the inflation rate in order to make sure that that dynamic does not take hold.

JS Yeah.

PL Now what is true is, and this is where the supply shocks come into it, is that in late 22 inflation was 10.6. We did not raise interest rates by more than 10.6. So what was important was not the inflation rate right now, but what’s expected over the next year or two. And that because some of these shocks could be counted to either stop or even reverse. When you look ahead to the inflation rate that might be expected over the next year or two, it was always a lot lower than that. So what we had to do… If you look now, we have the policy rate, even after the cut we made in June, at 3.75%. We have inflation one year from now, more or less at 2%. So on that calculation, the interest rate is a lot higher than the expected inflation rate. You have to be in that situation, I think. And that’s essentially what the first job of monetary policy is: don’t make the problem worse.

JS Yeah.

PL (28:04) And then the second job is…Because by raising the interest rate, you lower demand in the economy, and you accelerate the return…. So it’s not just the shocks expiring, if you like. You want to, actually, go a bit more quickly than that, and that’s where the restrictive demand comes into play. And what we’ve seen in Europe in the last couple of years is… the sectors where interest rates are very important, like construction, investment and so on, they’ve been very much affected by the high interest rates.

JS Before we get to that, I just want to highlight sort of this, I think, still relatively subtle points that maybe people don’t think about that much, which is indeed like real interest rates versus nominal interest rates, which is that if you had the nominal interest rate, which is what you communicate to the world at, let’s say, 0% or a little bit negative, and inflation is at 4% then you effectively have a super negative, or a really negative interest rate. In Turkey we saw where there was 80% inflation, and then interest rates were, off the top of my head, I think in the high 20s or in the 30s or something. And then people were saying, but these are super high interest rates…. But, you know, if you correct for inflation, they’re actually extremely low. So essentially, as a central bank, I could imagine that even if you are, as they would say, dovish, thinking that inflation will come down again, you have to follow it somewhat at some point, because otherwise you just have a really negative interest rate which is not appropriate.

PL Yeah. So I think this kind of distinction in more dovish and more hawkish individuals is, I think, not the context what we’re talking about. This is central banking 101. You have to make sure, in this situation that interest rates go up or not, they don’t add to the problem by having, if you like, the kind of speculative incentives you would have with very negative real interest rates.

JS Yeah. And then you mentioned, okay, interest rates went up and they have already had an effect in certain sectors, specifically like construction and maybe investments for firms as well…

PL (30:31) When you look at the economy, you can think about what we call interest rate sensitive sectors. So construction is one, because, of course, if you think about a building that’s going to last for 30 years, it’s very natural that a lot of that building cost will be financed by debt. So by raising the interest rate, you make that more expensive, and therefore the demand goes down for construction. The same is true for investment in equipment or in building a new factory. The same is true as an individual in terms of, for example, renovating a house, a new kitchen, Think about buying a car and so on. So there are those sectors where demand will respond quite a bit to the increase in interest rates.

JS And there’s a criticism out there, and I wonder how you would respond to that, which is that, because these are the sectors that are so sensitive, you are actually adding to the inflation problem in the sense that, for example, in housing, like a major part has been that there has not been enough housing construction, and then one of the first casualties is housing construction. And then same can be said for firms, right? Like we need all of this new investment now in green energy to get rid of the Russian gas in that part of the energy solution. Now we’re raising interest rates. How would you respond to that?

PL I think you cannot wish the problem away. We had high inflation. The recipe, which I think is inescapable, meant we have to raise interest rates. But what is fundamentally central to everything is that it succeeds, and it succeeds if inflation, as we think is happening, comes down rather quickly to our 2% target. Because what does that mean? It means over time, we can walk back from the high level of interest rates. And in turn, as we walk back from the high level of interest rates, that will allow these sectors to resume, will allow construction to resume, green investment to resume. But let me just in a side comment here that on the fiscal side, the Next Generation EU and other programs have tried to protect green investment to a significant extent. So I’m very comfortable with the ranking here, which is, if we’d kept interest rates low, I’m pretty sure inflation would not have come down. And in fact, we could have had a longer term problem. And that’s when you come to the Paul Volcker scenario. So Paul Volcker came in at the end of 1970s when inflation in the US had not come down. And then you have to do something very painful, which is a really big increase in real interest rates, most likely causing a very big recession and a big destruction in investment. So if you like to avoid that scenario, we have to be proactive. We certainly did not react immediately when inflation started to rise. But once we saw, a few months later, this was… this is something we had to do then, then we were decisive. And this is essentially, for those who are concerned about the housing shortages we do have in Europe, or the shortfall in green investment, I think everyone has to be a lot happier in the world where inflation comes back to normal, therefore eventually allowing interest rates to normalize than if we had had a kind of decade long or longer problem with high inflation, which would lead to this higher and higher interest rates to kill it. So this kind of a preemptive approach was, I think, more fundamental, because the alternative is not a kind of indefinite investment boom. I think the alternative would have been inflation remaining too high for too long.

JS (34:53) So could we say, okay, like we recognize that maybe some sectors are, you know, an unfortunate victim of an Interest rate increase. But I think economists always talk about how, how monetary policy, interest rate setting, is a blunt tool, but in this case, it was still necessary to keep expectations in check? And then I hear somewhere that, you know, you say, but actually, if we want to target certain sectors, then fiscal policy that is government spending or promoting investments can actually do that independent of our interest rates, which are just needed to control inflation. Is that fair?

PL Let me try to break that down into segments. In general, fiscal policy is better suited to dealing with sector specific problems. Because, as you say, there’s only one interest rate policy. We cannot cater to individual sectors. It’s also, I think, fairly commonplace, [to say] that, by and large, fiscal policy is a slow moving beast. It’s very hard to be very responsive with fiscal policy. Now, there are exceptions in this time period. This is an unusual time period. So in relation to the pandemic we already talked about, there were a lot of fiscal transfers that had to be made to households and firms to keep them going. Then I also mentioned Next Generation EU, where essentially, as part of the overall recovery in Europe, there was a multi-year program which rolls out to 2026 to stimulate especially investment in the green transition, in digitalization across Europe, more important for some countries than for others. That is still ongoing. That has been an important protector of investment.

JS Yeah.

PL What I would say also, of course, now with the Russian invasion of Ukraine, there’s also been, I think, an imperative for many governments to raise their defense spending.

JS Germany has already raised it by a lot, right? Above 2%.

PL (37:17) So there has been in this period…. And maybe fine [?] with the energy… So one fiscal challenge was the pandemic. Then you have the defense challenge. But then with the really sharp increase in energy prices in 2022 I think was very important for governments to support households to deal with that. And there was a lot of extra fiscal spending to provide some subsidies, in different ways across Europe. So there has been a lot of fiscal activity in this time period. And of course, what’s going to be very important as we see the recovery continue… And let me say, from our point of view, the European economy did not grow very much last year. But we do see now for the rest of this year and next year and into 2026 a recovering European economy, which will allow the private sector to provide more spending support to the European economy. And it’s important for governments, having done quite a lot, to normalize their fiscal positions. And this transition, this handover between public and private, it’s very natural from a macroeconomic point of view, but of course politically challenging to deliver that.

JS So do I hear in that a little bit like that now is the time - and I think we’re going to transition to the future of inflation and interest rates - now that as you mentioned, governments have spent way more than than they usually did for very good reasons – namely crisis after crisis after crisis. Are you saying that now? So, to get inflation to stick around the target, we need governments to start spending a little bit less and for the private sector to pick up again?

PL I wouldn’t center it on inflation. But more generally, I think if you want fiscal policy to respond, as you say, to these crises, when you’re out of crisis mode, fiscal policy has to step back. Already this year, we are seeing it that those energy subsidies that they brought in in 2022 by and large, more quickly in some countries than others, are being rolled back. Many pandemic supports have been rolled back. So there has been a lot of expiration of extraordinary measures. And what have is essentially the legacy: debt levels of governments in Europe did go up in recent years, and this is why the European fiscal framework [is saying] it’s not some kind of big one-year-only adjustment. It’s essentially stretching out over the next number of years, I anticipate in many countries, even over the next seven years and indeed longer and it will have to be in a mode of normalization. We have to bring the deficits down to a level that will make sure our debt levels will be sustainable into the future. It is a gear shift, but it’s not kind of, if you like, driven by some immediate crisis. It’s just driven by the basic principle that after extraordinary measures you have to normalize.

JS But if you say, for debt levels to be sustainable, do you think that they have to start falling again a little bit or stay roughly at this level?

PL Well, here’s rather than having a kind of unique message, because debt levels are very different across the European countries, this is where it’s going to be an interaction between each member state and the European Commission. And that’s the right forum for thinking country by country. So let me leave it [at that], [inaudible] from my perspective, sitting here the ECB. The overall pattern is clear, but the exact recipe for each country needs to be, I think, decided first and foremost at the national level, but then in dialog with the European Commission.

JS And where do you see - because I do think fiscal policy and all of these crises are going to play a big role in sort of the dynamic between interest rates and inflation for the upcoming years or decades. How do you see this? Like I think there is this general view that we’re coming out of this low inflation, super low interest rate world. And as you mentioned at the start of this conversation, there was the expectation before the pandemic, that we’re stuck in this but I’ve been sort of hearing more and more economists saying, actually now we believe that we’re not going back to that world anymore, and maybe we’re going to be in a world where interest rates, nominal interest rates, will be around 2 or 3% or something, and inflation will be around 2% rather than where it was 0% and negative nominal interest rates. Do you think that that’s the world we’re heading to? And if so, what are the main macro factors driving this?

PL Let me differentiate between three scenarios. One scenario is if inflation is too low, so below our target on an indefinite basis, that’s what we had before the pandemic. And our monetary policy strategy would say under those scenarios, you do have to have accommodative policies, so bringing interest rates down, maybe also doing quantitative easing and so on. So what’s probability of that scenario? And that’s where I think there is consensus right now. It’s not the most likely outcome.

JS Ok.

PL If you look back at that period, this is the period that came first and foremost after the global financial crisis, which really damaged the European and global economies and led to this kind of low demand situation, low investment situation. That is one scenario, which I don’t think is top of mind.

JS Which is huge, right? That’s a big change in the profession.

PL (44:07) Well, it’s a big change in the world. And looks at the world and looks at that. So, then the other two scenarios, one of which is, essentially, we’re in a world where maybe there’s no big, extraordinary shock, and we settle into some kind of steady equilibrium. And then the third scenario is we’re going to be hit by a wave of new shocks. And people have talked a lot about new shocks, which possibly will be creating more inflationary pressure than disinflationary pressure. Let me take that last scenario first. This does not necessarily mean by the way, that these shocks are going to lead us to having inflation with us indefinitely. But imagine that some new shock comes along, inflation pops up to even 3%. Then, of course, we would raise interest rates really back up. So that’s a world where on average, shocks are […?] above target, which means, on average, we have to raise interest rates above their equilibrium level.

JS Yeah. That’s a higher interest rate world, for a longer time.

PL Yeah, but that goes back to… That is the appropriate response if you see those shocks. But then I think… With shocks, by definition, it’s hard to know when or if they’re going to happen. So the other debate is, where is the equilibrium? Where is that long run equilibrium, if there’s no shocks. And this is where…

JS So, that’s the final scenario?

PL Right. But a scenario where, essentially, we settle down. And the question is what is the interest rate we need to keep inflation at two. And essentially it’s still the case. A lot of the research, including here at the ECB, would say that that interest rate remains relatively [or: roughly?] low. So you get a scenario where maybe the policy rate will be somewhere between two and three. We published estimates in our Economic Bulletin earlier this year, where a lot of the estimates were essentially [saying] that the real interest rate would be around zero, which means a policy rate around 2, when you add 2% inflation. But there’s definitely more weight now on a little bit above two as well. We publish external views - the Survey of Monetary Analysts, which your viewers can find on our website. And the most popular answer in that survey now is maybe two and a quarter, 2.25. Maybe 2.5, maybe 2. So that zone of 2, 2.5, let’s see what happens. Going much beyond that, I think you would have to say, okay, for some reason why we’re moving into a world either with more investment demand or less saving. And this goes back [to what we discussed before] and it very interesting. Will we see a very strong green transition. Will we see a surge of investment driven by the green transition? Will we see an investment surge driven, for example, by the opportunities of AI? These things are possible, but this is where it comes back to ‘we’re very evidence-based’. If we see this, then we would respond. But on the other hand, we also know the European population is aging, and aging typically is involved with low investment and high savings, especially when there’s maybe within that aging aggregate, increasing longevity. It’s very good news that longevity is increasing, especially if those extra years have high quality of life attached to them. But essentially, what that means is either people work longer or they have to save more for retirement.

JS Yeah.

PL (48:16) Anyway, I think it’s a very interesting debate. But for your viewers, coming back to our role: our role is not to essentially precommit to any particular vision of where this is going to be. The world will tell us. The world will tell us, as the world evolves, will we see high investment? Will we see lower investment, lower savings? What will be the attitude to risk? One big issue from the pandemic, the war, the green [transition], the heating [?] of the economy, is essentially the attitude of individuals and firms to this uncertainty. We live in a very uncertain world. And what does that mean for savings rates for investment rates, and that’s going to be one of the big questions for the coming years.

JS I think it’s really interesting that you know, when you talk about these two scenarios, maybe there’s this very high risk scenario where high inflation and high interest rate scenario, where you’re talking about shocks. I would interpret that as geopolitical shocks, maybe like continued geopolitical shocks after the Ukraine war. Maybe you have something else in mind. But then the second scenario where interest rates are still higher than what they were before, inflation is typically higher. They go along with each other. And then you mentioned these three key trends where there’s one, like big investments or innovation, which are actually really positive trends, but could mean higher inflation and thus high interest rates. And then the second: aging, which I think was talked a lot about before the pandemic, as the deflationary trend. But now I also see more and more people saying maybe, Professor Charles Goodhart is one of them, saying maybe the aging thing caused the deflation before people actually reached the age of retirement. But that may flip, where people will… where you have this huge demographic [trend] that they’re spending actually a lot because they’re already retired. But, okay, maybe that’s a whole other discussion.

PL It’s a lively debate about aging. So that’s why I kind of more specifically about longevity.

JS Because then you have to save much longer, right?

PL Right. So, I think there’s still a lot to think about with that. And of course, you have to think about the world aging, not just the European economy aging. But let me come back to the… And this is, I think, very important. You were saying, well, these various shocks or trends could be inflationary. At some level, I think that’s not the way to think about it, in the sense of ‘Yes, shocks, if something unexpected happens, then you could see a surge in prices or a collapse in prices as an immediate response’. And I do think probably this consensus, in a more geopolitically fragmented world, we could see inflation becoming more volatile.

JS Right. Okay, so maybe not inflationary, just more volatile.

PL That’s one element. But the other element is it’s not so much that you might see, because if we do our job for the predictable part, if we can see something that it’s not a shock, it’s kind of an established trend, then essentially, we would keep interest interest rates in line with that. So you might not see any inflation…

JS Yeah, but then you see higher interest rates?

PL (51:57) Exactly. Or lower, depending on the nature of what you’re looking at, yeah. So this is for some of your viewers who have studied the Phillips Curve to some extent. And this is, if you like, one of the kind of main puzzles in trying to look at the data. As central banks, we do try to anticipate where we can. You might see the ideal is a world where, if you don’t have shocks, inflation is around two but the interest rate needed to live by 2% [inaudible]. But then, of course, when you added shocks, then you get the volatility, and then you get also this kind of cyclical response, which is what we’ve done now, which is essentially a number of years high interest rates, but then if inflation stabilizes back to target, rates will come down, and that’ll be an interest rate cycle around some longer run equilibrium channels [?].

JS Right. I think that is something to think about for a long time for people after watching this video. Thank you so much for talking to me, taking us through the whole thing, start to finish, and with a little bit of a preview of possibilities. And I think you also emphasized there something that I see with many central bankers: this emphasis that you do not have a crystal ball, you cannot look into the future, but you are looking at scenarios, and you are acting and accordingly and changing the probabilities of these scenarios, perhaps in your head, based on the evidence that’s slowly coming in.

PL And because of that we meet every six weeks, because the world can change, and that’s why some people think about this on a kind of abstract level. Of course we do that also, but we also know we can adjust our policy every few weeks.

JS Excellent. Thank you for this inside look into the mind of a central banker.

PL My pleasure.

My summary

So, I hope that conversation gave you some valuable insights into how the ECB views the future, and the past of inflation & interest rates.

For me personally there were three stand-out insights about the previous inflation spike that I had not considered before. The first is that that Philip Lane argued that a lot of why the money supply increased so rapidly in Europe during Covid came from firms taking out additional loans with private banks to continue paying employees throughout the lockdowns. This, together with higher interest rates, could explain why the money supply in a country like France now again on pre-covid trend. A second, subtle, insight I thought was interesting is that Lane told us that the ECB raised rates by less than it could have to give wages a chance to catch up to other increased prices. Thirdly, I thought it was really interesting that mr. Lane acknowledged that higher interest rates could increase inflation in the future by lowering investment now. For example by slowing down housing construction or investment in new energy sources. However, there he did make the point that these unwanted sector specific effects can be offset by increased government spending or incentives.

Finally, when it comes to the future, it really stuck out to me that the ECB thinks in terms of 3 scenarios. The first scenario is a return to the pre-pandemic trend of ultra low inflation and therefore ultra low interest rates. It considers this scenario unlikely because of big trends like an ageing society in which retirees spend more or a big investment surge driven by the energy transition or A.I. These trends could push us into a second scenario, which is a fairly stable scenario where both inflation and interest rates settle around 2-3%, meaning that the real interest rates will be around 0%. Finally, the third scenario also has higher inflation and interest, like the second, but in this scenario, we will more volatile inflation shocks which will then mean that the ECB will need to respond with again temporarily higher interest rates, a primary reason we will find ourselves in this scenario could be geopolitical fragmentation.

Food for thought.

But before we end the video, I just want to say that, I tried to keep this conversation as accessible as I could, without loosing, hopefully, too much depth. But, this is quite a technical subject, so if anything is unclear, feel free to ask me questions in the comments. I will try to answer them.

And, if you like this type of content, bringing in depth economics to a broader audience, then please consider supporting my work via Patreon or by becoming a member. Money & Macro is still largely a one man show. But, to create more content I really need to outsource some more stuff and to pay for this I really need a steady base of income. Specifically, with a 100 more Patrons or so, I can start looking for an economist or journalist to help me to make more content.

So, yeah, if you want more content, your help, really helps, please support the channel by becoming a long-term Patron at patreon.com/moneymacro