ECB chief economist: Not seeing a 'toxic mix' that would spur deep recession

Last week, the European Central Bank raised rates by a quarter of a percentage point to 4%, but suggested that they will be done with rate increases for a bit. ECB Chief Economist Philip Lane tells Yahoo Finance that the 4% interest rate "is going to do quite a bit in bringing inflation all the way back to our 2% target." However, Lane notes that there is still a lot of uncertainty and though "we do think that this 4% will do a lot," that rate needs to held long enough to bring inflation down. Lane also cautions that the bank remains data dependent.

Lane also tells Yahoo Finance's Jennifer Schonberger that "the overall environment remains... not fragile." "The banking system is in good shape. Because of the pandemic, household balance sheets look in better shape than normal. Same for corporates. So the kind of toxic mix... you need in order to kind of trigger a deep recession is not present," Lane says.

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Video Transcript

JENNIFER SCHONBERGER: Joining me now in an exclusive interview is Philip Lane, chief economist of the European Central Bank and former head of the Bank of Ireland. Dr. Lane, welcome to Yahoo Finance. Thank you so much for joining me.

PHILIP LANE: Good morning. It's a pleasure to be here.

JENNIFER SCHONBERGER: So you opted to raise rates for the 10th time last week, bringing rates to an all time high of 4%. In the eurozone inflation, still stuck above 5%. Yet you seem to have signaled that you're finished raising rates. Why? Could you explain?

PHILIP LANE: Well, I think the way to think about it is we think inflation will come down from low fives in August to low threes by the end of this year. So last autumn was really the peak of an intense inflation pressure. We had a very strong gas price increases last year, which peaked in the August 22. And essentially, this autumn, there will be base effects where that 5% inflation rate comes down into the threes.

So the 4% interest rate, if you like, is there to bring inflation from around 3% at the end of this year back to 2% in '25. That's the scale of, if you like, the underlying inflation challenge. And this is why this rate of 4% we think is going to do quite a bit in bringing inflation all the way back to our 2% target.

JENNIFER SCHONBERGER: So then do you believe keeping rates at current levels is enough to bring inflation back down to target if held for an extended time, and thus, further rate hikes are off the table at this point?

PHILIP LANE: So I think we have a lot of evidence in the euro area that monetary policy is working. Credit is basically flat now. It's come down from strong credit growth to where lending to firms and households is pretty muted. The economy is growing at a very low rate. So all of the signals are there, but monetary policy is working. There's more slack being built up in the economy. And this we think will make sure that over the next year or two, price increases and the underlying cost increases such as wages will remain fairly contained.

But as you just said yourself and the way you phrased it, this is a point in time assessment from last week. I think the overriding message, which I think is global really from central banks, is high uncertainty. And so we're emphasizing that we do think this 4% rate will do a lot, but we're also I think loud and clear in saying, number one, this rate has to be held for long enough to make sure inflation is firmly on its way back to 2%. So there's a lot of power in the messaging that this needs to be held for sufficiently long.

And then second, we're totally open in adjusting our policy over the next year or two as we see the incoming data. So still very data-dependent. We're sending a point in time conditional message in terms of what we saw last week and this decision. But of course, we meet every few weeks.

What I said last night when I spoke here in New York is there's going to be a lot of data points really not just at the end of this year but stretching well into next year that we need to see before we would have a high confidence that indeed, inflation is firmly on its way back to our target.

JENNIFER SCHONBERGER: So then base case, it sounds like you are prepared to hold rates for an extended period. But if you need to, you would raise interest rates again?

PHILIP LANE: Well, I think this is totally straightforward. All central banks have to be in a situation these days where it's not a good idea. It's not productive. It's unhelpful to kind of commit to a forward guidance where we say these rates are going to be held no matter what.

But equally, I mean, I think this message should not be overinterpreted. You would expect a central bank, if we saw the inflation assessment going off track. If we saw I think the net signals from the incoming data saying that that actually more is needed. Of course, we would do more. But that is purely a process issue. It's saying in response to kind of sufficient deterioration in the inflation dynamic, we would do more. And that's just reflective of the uncertainty we're living in this these conditions.

JENNIFER SCHONBERGER: As you look to hold for an extended period, what ballpark does that look like to you? Is it at least through next year given how you expect data to evolve?

PHILIP LANE: So I think it's important to really take a look at the calendar. So I don't think it's a good idea to kind of give calendar guidance such as you were trying to suggest there. But what I did say last night is that, for example, one of the big issues in the European case would be where wages come in 2024?

And maybe a bit differently to here in the US, a lot of wage negotiations is episodic. A lot of wage settlements for '24 will only take place in January, February of '24. So in many countries, there's kind of institutional settings where there might be a once a year reset. And so we're not going to know about 2024 wages really well into 2024. And that's one of the key elements in the dynamic we need to see for inflation to come back.

So that's not a complete kind of dimension. It's just one dimension. But it's a very important dimension in thinking about the calendar that we will be following and looking at the incoming data. I mean, another way of saying that is really this autumn, we will learn a lot, but we're not going to learn everything. So it is going to be I think a topic that's going to be stretching well into the new year in terms of understanding the data we need to see in order to move further in the adjustment back towards, if you like, the target for inflation, which in turn at some point will unlock a kind of normalization of monetary policy.

JENNIFER SCHONBERGER: You've lowered your growth forecast significantly for this year and next. You now see growth of 1% or less. Some market watchers are concerned about the somewhat fragility of the eurozone economy, especially if you were to hike rates again, though I know you're very data-dependent. But how is the ECB looking at that right now? Are the risks to the downside?

PHILIP LANE: So let me characterize it as essentially this year, 2023, we only have three months to go at this point. We do see this year as being fairly muted. An economy that's not growing very much. And then we do have a pickup really from the start of next year because this year, I mean, the legacy of the pandemic. The legacy of the massive 2022 energy shock. The connected problems with the with the war and so on. Is that there's a lot of reasons for this year for the economy to stagnate.

But as incomes go up, and remember, basically from this point forward, we do think wages will grow more quickly than inflation. People's incomes are going to pick up. And this will help consumption. On the investment side, there's been a big adjustment for a year and a half now We've seen construction. This already started happening in early '22. And as that adjustment concludes, we will start to see I think investment returning.

Let me emphasize. It is the overall environment remains, if you like, not fragile. The banking system is in good shape. Because of the pandemic, household balance sheets look in better shape than normal. Same for corporates. So the kind of toxic mix, if you like, you need in order to kind of trigger a deep recession is not present.

So this monetary tightening, which we need to do to kill inflation, is in a context where we don't see the fragilities that happened 15 years ago. So it's very much you know a special situation where the monetary tightening can bring inflation back to target, which absolutely does slow down the economy. But this is slowing an economy which has momentum, has resilience. And we do expect to see a pickup next year and the year after, which will bring the European economy to grow. So we have unemployment you know rising but to a very limited extent. So it's a very unusual disinflation episode.

JENNIFER SCHONBERGER: Is Europe in a better position this fall and winter given the ongoing war in Ukraine when it comes to energy? That if energy prices were to spike, you are in a better position to handle that? Certainly we have already seen global supply cuts from Saudi Arabia and Russia. Brent Crude at $100 a barrel or so. But how are you looking at that and the possibility of that creeping into core inflation and causing inflation to remain elevated for longer?

PHILIP LANE: So this is why we did raise the inflation forecast for this year and next because of that material change in the outlook for oil over the summer. What you just referred to is a very important factor we will be looking at, is will it broaden out? Will higher energy costs trigger a new round of price increases across the services sector, across manufacturing?

And what I would say in relation to that is historically, there was a limited pass through from energy to wider indicators, and the environment now is quite different to a year ago. So with these restrictive interest rates, with relatively contained demand conditions, a firm might wish to pass on high energy costs to their customers, but they're much more at risk this year of losing market share if they try to do so.

So we do think-- this is by the way one of the reasons I cited last night for the move to 4% interest rates, is it will moderate any, if you like, possibility that an energy shock or a food shock, we are concerned about food prices, that the ability of that to amplify into core inflation is less at a higher interest rate. So interest rates now are much higher than a year ago. And so that kind of amplification effect, I think that risk is lower today than it was a year ago.