MNI EXCLUSIVE: ECB Should Hike As Market Fears Wane - Kazaks

The European Central Bank should keep to its baseline economic scenario and continue to raise rates to bring inflation back to target before 2025 as fears of a banking crisis recede, Bank of Latvia governor Martins Kazaks told MNI.

"It's way too early - even with headline inflation starting to come down - to declare any kind of victory with respect to inflation," Kazaks said in an interview, though he noted that it is still hard to measure the extent of any slowdown in the flow of credit following the collapse of Silicon Valley Bank and the forced takeover of Credit Suisse, making it more difficult to assess how high the ECB will have to hike rates.

"If the baseline scenario remains, we will need more rate increases to push inflation back to 2% in a reasonable period of time," he said. "The current baseline macro scenario is that we need more rate increases, and if anything I think it would be beneficial for the economy to see inflation approaching 2% earlier than 2025."

But there are still “too many moving parts” to quantify the effect of recent credit tightening, and its impact on the level at which interest rates settle and the length of time they remain there.

"If there is increased sensitivity through the credit channel and the confidence channel, then the transmission may become potentially stronger,” he said. “The higher we climb, the more cautious we have to be, because the risks become two-sided - although the risks of doing too much are in my view much easier to deal with.”

BETTER TO OVERSHOOT THAN UNDERSHOOT TARGET

While rate-setters would ideally neither overshoot nor undershoot their inflation rate target, "if we raise the rates by 25 basis points too much we can always come down. If we raise by less and inflation starts to come back, then we will need to raise rates much more than 25 basis points to reinstate confidence.”

The Governing Council is following financial markets “very carefully” for signs of distress, Kazaks said, adding that sharp corrections could affect the economic and inflation outlook, but that while more pockets of risk are likely to exist within the financial system, officials will respond to them as they emerge.

“Institutions are doing their best, in my view, and so far all those systemic risks have been dealt with.”

Having told MNI last month that the ECB could end reinvestments from its asset purchase programme in the third quarter of 2023, Kazaks noted that liquidity remains ample and that the central bank has the tools to support the market if necessary. (See MNI INTERVIEW: ECB Could End APP Reinvestments In Q3 - Kazaks)

Referring to comments by ECB President Christine Lagarde, who said that the central bank could consider whether to deploy its Transmission Protection Instrument in response to financial tensions, Kazaks said its purpose was not in doubt.

“TPI is designed to do exactly as its name describes, so if we did see a need to engage it, we would.”

But other tools - and coordinated central bank action - would be the first line of defence, he said.

“There are many other instruments at our disposal. And if it is a global issue then it is in global central banks’ interests to support not only national or regional policies, but to come up with mutual decisions that improve the stability of financial markets.”