“There is no magic that works forever”

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Frankfurt Finnish central bank chief Olli Rehn fears that the current crisis will exaggerate the financial markets. “One of the unusual phenomena in this crisis is the decoupling of the markets, especially the stock market, from the real economy,” said the Governing Council member in an interview with Handelsblatt.

However, the central banks are not to blame for this development. With their monetary policy, they would only follow a trend towards ever lower interest rates, but would not determine it themselves.

At its meeting in June, the Council of the European Central Bank (ECB) decided to expand the bond purchase program in the corona crisis, known as PEPP, by EUR 600 billion to a total of EUR 1.35 trillion. Rehn made it clear that despite all the flexibility, purchases are based on the ECB’s capital key, which is based on the population and economic strength of the euro countries. The capital key remains in the PEPP program “the anchor to which purchases must ultimately converge”.

The Finnish central bank chief opposed the suggestion that the ECB should seek explicit margins for long-term government bond yields in the euro area. “I don’t think there is a scientific method by which one can determine the appropriate level of yield.” Other central banks, such as the Bank of Japan, are pursuing a strategy to control the yield curve, in which they do not only set a target for short-term interest rates , but also for the long term.

With regard to the inflation outlook, Rehn assumes that the Covid 19 pandemic will have a dampening effect on prices in the short and medium term. “In addition, the risk of deflation has reappeared.” There was a supply and a demand crisis, but above all there was no demand, which tends to depress prices.

Despite these prospects, one must also observe the risks of higher inflation. “There is no magic that works forever.” If inflation should rise again at some point, the ECB will respond, “Nobody can fool itself”.

Read the entire interview with the Finnish central bank chief here:

Mr. Rehn, last week Austria issued a 100-year bond for less than a percent return. More and more economists are worried that the capital markets are too dependent on the central banks and no longer reflect reality. What do you think?
These are exceptional times for the global economy. One of the unusual phenomena in this crisis is the decoupling of the markets, especially the stock market, from the real economy. But you also have to ask yourself what’s behind it. The central banks tend to follow a trend towards ever lower interest rates, they do not determine this trend.

But the European Central Bank (ECB) sets the deposit rate and dampens yields through bond purchases.
For the ECB, the neutral equilibrium rate is an important indicator …

… the interest rate that enables full employment without higher inflation.
Yes, and this real equilibrium interest rate has continued to fall after the economists have largely agreed. The reasons are the aging of the population, which leads to a higher savings rate, globalization and, in Europe, the free movement of workers, which is slowing the rise in wages and prices. Added to this are the – possibly even permanent – effects of the corona pandemic.

The central banks have always invented new instruments in the financial crisis a good ten years ago in order to loosen monetary policy even further despite the already very low key interest rates. Will the ECB soon start steering the yield curve, that is, striving for an explicit margin for long-term yields?
Other central banks, especially the Bank of Japan, have already done so. The ECB primarily used its monetary policy instruments to stabilize the markets. It can buy bonds relatively flexibly through the PEPP program to ensure the transfer of monetary policy to the economy. Nevertheless, the capital key remains the anchor in the PEPP program, to which the purchases ultimately have to converge.

We have managed to improve the transfer of monetary policy across the currency area. The difference in yields between government bonds has narrowed. But I don’t think there is a scientific method to determine the appropriate level of returns.

An innovative instrument are medium-term, discounted loans to banks, the so-called TLTROs. Most recently, they were accessed with a record volume of 1.3 trillion euros. Is there a risk that bad loans will accumulate in the bank balance sheets?
These TLTROs are designed to strengthen lending to medium and small businesses. After the financial crisis, banks cut their balance sheets for years by cutting back on lending. That burdened the economy. We have to stop this downward spiral. The high demand for the new TLTROs is a positive sign that hopefully reflects a loosening of credit conditions in the euro area. But of course we should also be careful that the loans are not used to finance too many zombie companies, i.e. companies that are actually not viable.

In the meantime, there was talk of the ECB setting up a so-called bad bank, a collection point for bad credit risks. What do you make of it?
I can still well remember the banking crisis in Finland in the early 1990s, where we successfully used such a bad bank. But it may not make sense to install that at European level. You need a very good knowledge of the national and regional real estate markets in particular.

So would national solutions make more sense if there was a need?
We had a successful bad bank in Spain after the financial crisis. It was endowed with 100 billion euros, of which only 43 billion were needed. This enabled a very professional restructuring of the banks there.

How big do you think the economic damage will be from the pandemic?
The ECB has three scenarios, one with minus six percent in growth in the current year, one with minus nine percent and the worst with minus 13 percent. I think the middle variant is likely, but I don’t want to rule out the worst either.

In many countries, the economy is slowly reopening.
Yes, but export nations like Germany in particular are dependent on the recovery of the global economy. This also applies to Finland, where 100,000 fewer people are now employed than before the Covid 19 crisis. The number is similar to that in the financial crisis.

Is there any prospect of improvement?
After the pandemic started in China and spread to Europe and then to the United States, we are now experiencing the fourth phase, when the epidemic will hit the emerging markets. So far, 70 countries have received help from the International Monetary Fund (IMF). Case numbers are still increasing in three major countries, the United States, India and Brazil.

When do you think the European economy will return to the pre-crisis level?
If there is not a serious second wave of the pandemic with appropriate countermeasures, this could be the case in around two years.

And how long will it take before countries in the euro area have reduced the mountains of debt they are accumulating to combat the crisis?
Much longer. In the financial crisis, debt grew from 60 to 90 percent of gross domestic product (GDP). That has wiped out around two decades of debt reduction. Now we also have to expect a 15 to 20 percentage point increase in debt.

Isn’t that too dangerous?
Germany has reacted very strongly in terms of fiscal policy, and that is very welcome. Unfortunately, not all euro countries have a similarly wide scope. But overall, the economic crisis is severe and requires a strong monetary and fiscal stimulus. It is true that the ECB acted swiftly and proportionately, which has led to an increase in its balance sheet. The stimulus measures relax general credit conditions and balance the fact that households save more.

Doesn’t that drive inflation up in the long run?
In the short and apparently also in the medium term, the Covid 19 pandemic is more likely to dampen prices than inflation. In addition, the risk of deflation has reappeared. We have a supply and a demand crisis, but above all there is no demand. Initially, this tends to depress prices. But we have to watch the risks closely, there is no magic that works forever. If inflation should pick up again at some point, the ECB will react, and nobody can fool itself. Price stability is our mandate.

However, some countries cannot afford higher interest rates.
That is why my core message is: Governments must use the time of low interest rates for reforms that boost growth and create jobs. This will also make it possible to reduce the high level of public debt.

You just mentioned the ECB’s mandate. It is true that price stability is their primary mandate. But there is also a secondary mandate to support the general economic policy of the European Union (EU). This includes full employment, for example. Why is the ECB no longer talking about it, that would be more understandable to the general public than the discussion about decimal places in price developments?
First of all, price stability is set in the EU Treaty. Still, I wouldn’t call full employment secondary. Like the fight against climate change, this is an important goal that we support unless price stability is compromised.

ECB President Christine Lagarde has promised better communication. What has become of it?
Under President Lagarde, the ECB is very focused on providing citizens with understandable communication. This is part of our big strategy review debate that we had to postpone until September because of Corona. But of course we are already preparing them in the background.

How should the environmental issue be considered?
In the Finnish central bank, we have already decided to avoid investing in environmentally harmful areas, such as climate-damaging industries, in accordance with the United Nations’ principles for responsible investing. I will work to ensure that this also happens at the European level.

More: Commentary on the solution after the ECB ruling: The end of a bad comedy.

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