‘Last mile’ of disinflation the hardest, warns ECB deputy head

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Luis de Guindos has dismissed talk of rate cuts by the European Central Bank as “premature”, warning that hurdles over “the last mile” of bringing inflation back to rate-setters’ 2 per cent target will be tough to overcome.

The vice-president of the ECB has, along with other members of the bank’s governing council, been grappling with the sharpest rise in prices in a generation. The surge in inflation has forced them to raise its deposit rate an unprecedented 10 times in a row to an all-time high of 4 per cent.

While price pressures are now at a two-year low, De Guindos told the Financial Times the recent surge in oil prices to a 10-month high would “make our task more difficult”.

“We are on our way towards 2 per cent,” said de Guindos. “That’s clear. But we must monitor that very closely, as the last mile will not be easy . . . the elements that might torpedo the disinflation process are powerful.” 

Along with oil, rapid wage growth, a weaker euro and resilient demand for services could also keep inflation high.

“This is, at the end of the day, a very delicate balance,” he said, speaking a few days before eurozone inflation data was released on Friday showing it had fallen more than economists expected to 4.3 per cent in the year to September.

Luis de Guindos said the speed with which the ECB’s policy tightening is transmitted from banks and bond markets to consumers and businesses is ‘crucial’ © Peter Jülich/FT

Most economists think the eurozone economy is likely to shrink in the third quarter, contributing to a cooling of price pressures, making the ECB unlikely to raise rates further. 

Yet bond markets sold off heavily last week, sending government borrowing costs to their highest level since Europe’s debt crisis over a decade ago, as investors fretted about signals from central banks that they will keep rates high for a prolonged period before cutting them.

The remarks by De Guindos, a former executive at US bank Lehman Brothers when it collapsed in 2008 who went on to be Spanish economy minister, signal eurozone interest rates will remain high for some time yet.

The ECB vice-president told the FT the “crucial” factor determining its next move was the speed with which its policy tightening is transmitted from banks and bond markets to consumers and businesses.

Changes to monetary policy usually only take full effect on inflation after at least a year, meaning much of the impact from the ECB’s tightening could still lie ahead. But if policy transmission has been rapid and inflation remains high, he said the bank may need to take further action on rates.

“If the transmission is incomplete, then we should be a little more patient,” he said. “If the transmission is much closer to completion, then we should consider the next steps to guarantee that inflation converges to our target.”

Line chart of showing The ECB has raised interest rates more slowly than in the US and UK

The cost of borrowing has shot up and demand for loans has fallen — private sector lending in the eurozone rose 0.6 per cent in August, the slowest annual pace for eight years. But he said there was “much more uncertainty” over how fast this is transmitted to households and companies as many have locked in low rates for long periods, shielding them from the impact of the ECB’s policy tightening. 

Another factor keeping prices up is higher government spending. Last week Italy and France outlined plans to run bigger than expected fiscal deficits above the EU rule limiting them to 3 per cent of output, which has been suspended since the pandemic but is due to come back into force next year. 

Line chart of showing Lending to companies and households is drying up in Europe

“After four years without EU fiscal rules, governments may have got used to a little bit of a ‘whatever it takes’ approach with respect to fiscal policy,” said de Guindos. “But that has to change. Having a tightening of monetary policy and, simultaneously, an expansionary fiscal policy would be a very bad policy mix.”

The sharp increase in interest rates has caused property prices to fall in much of Europe, which de Guindos said was “our main source of concern in terms of financial stability”, in particular exposure of non-banks, such as mutual funds, to the property market.

Some ECB governing council members have called for a faster reduction of so-called “excess liquidity” in the banking system, which has fallen but remains high at about €3.7tn. These reserves inflict losses on national central banks that have to pay vast sums of interest to banks.

One way to address this is to increase the minimum reserves banks are required to hold at the ECB, on which they receive no interest. However, De Guindos pushed back on this idea, saying: “My opinion is that we should conduct monetary policy based on price stability, not on the profit and loss of national central banks.”

He seemed more amenable to the idea of ending reinvestments earlier than planned in the €1.7tn Pandemic Emergency Purchase Programme (PEPP) of bonds it started buying after Covid-19 hit.

“Some of my colleagues in the governing council have been quite outspoken with respect to the need for starting the process of quantitative tightening on the PEPP,” he said. While he said this idea had not yet been discussed, he added: “It will arrive sooner or later.”