Philip R. Lane: Interview with Les Echos

25 November 2024

The future President of the United States, Donald Trump, was elected on a highly protectionist programme. What does this mean for the global, and particularly the European, economy?

Right now, the US economy is growing well. Productivity is improving in the United States, also, perhaps in large part thanks to the adoption of artificial intelligence and other new technologies.

In this context, we will have to examine how the situation will evolve under the future US administration. For example, deregulation: will it accelerate investment activity in the United States? Will big cuts in corporate and personal taxation increase demand in the economy? Will lower immigration, or indeed a reversal of immigration, slow down the American economy? And will there be trade policies that are harmful for imports from the euro area?

For the net effect of all these policies on the US economy, there will be forces in both directions, but the net effect of protectionism on the global economy is clearly negative. The most important issue is that an increase in protectionism is bad for the world economy.

How will the euro area be affected?

The scale of the problem really depends on how widespread the protectionism is and how quickly it is implemented. There is a wide range of scenarios. If the increase in tariffs is rapid and universal, European firms will have little time to prepare and the risk of a big disruption will be very high.

If it is only partial – in other words, only imposed on selected products – and is only gradually implemented, it will still generate a lot of uncertainty. That uncertainty could inhibit investment in Europe and may also make consumers reluctant to spend.

The inflationary effects of Donald Trump’s intended policy may lead the US Federal Reserve to slow down its interest rate cuts. Could this affect the ECB’s room for manoeuvre, especially if it drives the euro down further against the dollar?

The euro area is a continental-sized economy. Trade is important, but we trade with the world, not just with the United States. We will set interest rates for Europe to ensure price stability in Europe. The exchange rate is a factor, but only one factor, and it is important not to isolate it from the full analysis. The EUR/USD rate will reflect the differences in growth and inflation between Europe and the United States. We will look at the overall level of demand in the European economy, domestic price pressures and those stemming from, for example, imports from China. And we will of course look at those emanating from the EUR/USD rate and the US economy.

But could this not cause inflation in the euro area to pick up again?

If the global economy is more protectionist, this will impair the growth rate of the European economy, and that will be likely to reduce inflationary pressures. On the other hand, if there is a lot of protectionism, import prices may be higher. So we will need to strike a balance in our assessment between external pressure on inflation – which may be stronger from the United States but weaker from China – and possibly less domestic pressure on inflation.

Doesn’t the difference in interest rates and the growth differential between the euro area and the United States risk inducing a flight of capital from Europe to the other side of the Atlantic?

If US firms have better profitability, a better dynamic than European firms, then European investors will invest more in US firms. At the same time, there is another reason for the attractiveness of the US capital market: it is much larger than the European one. So it’s not a question of prohibiting outward investment. It’s more about encouraging European investment.

Europe should make sure that there are no barriers to supporting European firms. That relates to what is known as the capital markets union and the many policy steps in this direction outlined in the recent reports by Mario Draghi and Enrico Letta. We at the ECB share that diagnosis and we advocate seeing Europe as a single economy, a single financial system.

Inflation in the euro area picked up slightly in October but remains at the ECB’s target of 2 per cent. Has the battle been won?

Inflation peaked in autumn 2022. Much of the focus of monetary policy has been to guide inflation from 10 per cent back to 2 per cent. So that process has been handled reasonably well. But it's not quite over, because we need services inflation to come down. What is most important for us now is to deliver inflation at 2 per cent on a sustainable basis. Inflation is close to the target at the moment but this essentially reflects a combination of energy prices falling and services inflation remaining high. Over the course of next year we need to see a kind of rebalancing: a decline in services inflation that allows us to reach the target, even if there’s some upward pressure on the prices for energy, food and goods. There is still some distance to go on adjustment to make this level more sustainable.

Do you still see upside risks for inflation?

We are facing many uncertainties, whether it’s the United States, geopolitical tensions in the Middle East or China’s industrial strategy. Some of them could push down inflation, but we also need to be aware of the upside risks. We’ll see how the world evolves in the coming months. Our monetary policy therefore needs to address both downside and upside risks.

The concept of the neutral rate [which neither slows down nor accelerates the economy, editor's note] is interesting, but I would question whether next year the world will be neutral, in the sense of there being no major shocks. Our focus is on bringing inflation back down to our 2 per cent target on a sustainable basis.

Still, do you think it might be useful to move faster on reducing interest rates?

We have been clear that we’re proceeding meeting by meeting, and we have not given specific forward guidance on the rate path. We will have new staff projections in December. We will consider how inflation is developing, but also the upside and downside risks. What I would say is that throughout 2023 there were still concerns that it would be difficult to come back down very quickly from a peak of 10 per cent inflation to 2 per cent. I think there’s probably less concern about that now than a year ago.

Regarding the situation in Europe, the euro area economy is pretty lacklustre right now. Are there reasons to hope for an improvement?

What we have is a cyclical recovery. This is also reflected in the European Commission forecast that came out last week. This year we are seeing household incomes improve, with wages in a number of countries rising faster than inflation. Sometimes this happens with a lag, which explains why the effects haven’t been very strong so far. But there are good reasons to believe that consumption will grow more strongly next year and in 2026. As interest rates come down, the construction sector, for example, should recover. But to turn a modest recovery into a really strong economy will require policy reforms for the integration of the European economy, as Mario Draghi argues in his report.

How long will it take for the effects of the interest rate hikes on the economy to wear off?

We had a very big and rapid series of rate hikes that finished in September 2023. Then we had nine months where we remained at a policy rate of 4 per cent. But as of autumn last year everyone could see that the inflation profile was improving and that, over time, the ECB would start dialling back the high interest rates. And so from that moment on, before the first actual rate cut in June 2024, some degree of the restrictiveness of our monetary policy disappeared from the market. But the very rapid hiking we have done has still really held back housing and investment this year and has been encouraging people to save more rather than consume more. So I think the restrictiveness is still in the system now. We do not pre-commit to a particular speed but, over time, rates will have to be reduced. Monetary policy should not remain too restrictive for too long. Otherwise, the economy will not grow sufficiently and inflation will, I believe, fall below the target.

When do you think we will achieve the right balance between growth and inflation? Next year?

Leaving aside any new risks stemming from geopolitics or policies elsewhere, focusing on the internal dynamics of the euro area economy, I think a lot of the final leg of bringing inflation back to its 2 per cent target on a sustainable basis could indeed be covered next year. So I think next year, in the absence of new shocks, this balance could be achieved in the sense that restrictive policy will no longer be needed.

The bond market has experienced several bouts of volatility and spread widening between interest rates for different euro area countries. Should we be worried about a new risk of fragmentation in the euro area?

It’s very important to distinguish between the orderly adjustment of yield spreads – which basically reflect changes in fundamentals, for example the size of public debt or growth prospects for the different economies – and fragmentation that becomes a sort of spiral with self-fulfilling situations, where investors become reluctant to buy this or that debt. We see none of that at the moment.

We have a European fiscal framework that provides guidelines, a mandate for fiscal adjustment on a phased, multi-year basis. All European governments, all European political systems, should work within that framework.

Do you think that European Union bonds could be the safe assets for the euro area that everyone has been calling for, for years?

If the Member States reached agreement on a kind of common fiscal capacity, one of the benefits would be that European Union-level bonds – if these were available on a more permanent basis and had greater liquidity – could provide an important safe asset. But I don’t think we should pretend that Europe is going to move towards a federal model like that of the United States.

What we want to have is a mix of European Union-level bonds and also national bonds of as high a quality as possible. This brings us back to making sure that the fiscal framework is implemented and that there are no concerns about the sustainability of debt in Europe.