Peter Praet: We will see low rates for a long time

English2020. máj 14.Harsányi Péter

The former chief economist and executive board member of the ECB told novekedes.hu that in short to medium term negative demand shocks and deflationary forces will dominate. As a result, central banks follow very expansionary quantitative easing policies to lower interest rates and financing costs. According to Peter Praet without reducing taxes on labor the previously seen employment levels across Europe are difficult to achieve quickly.

In your view, how effectively can central bank measures mitigate the negative economic effects of the coronavirus epidemic?

Central banks can provide liquidity and cheap loans to the banking sector, can prevent significant volatility and fire sale of assets. However, it is clear that given the type and the size of the shock a supportive fiscal policy is absolutely indispensable. Only with a combination of monetary and fiscal policy it is possible to effectively cope with the negative short-term adverse effects of the coronavirus epidemic. One must consider the policy measures that have been taken in a comprehensive way.

In many countries the balance sheet of central banks will increase by at least 20 percentage points of GDP as a result of the asset purchase programs and other measures like funding for lending. That is a huge increase.

Meanwhile the activated automatic stabilizers, the discretionary fiscal measures and the falling GDP numbers will result in a significant increase in the public debt to GDP ratios. Consequently, public debt to GDP could soar by around 20 percentage points in advanced economies.

Earlier you said "If you print enough money, you will always get inflation." Given the coronavirus disinflationary effects, the structural problems of some EU-member states and low oil prices, do you think that Eurozone inflation can return to the 2 percent target over the medium term with the help of ECB's current asset purchase and liquidity-providing programs?

It is a very important question. Before the COVID-19 shock it was already difficult for many central banks to reach their inflation targets. It was a discussion whether the European Central Bank should provide additional measures to revive inflation. In September 2019 the ECB provided broad based expansionary measures in order to bring inflation back close to 2 percent over the medium term.

Europe and the Euro area are not in a good position, as their growth and inflation numbers were already low before the coronavirus pandemic escalated. There were also divergences in peripheral countries like in Italy.

Positive is that banks are well capitalized today compared to the situation in 2008, although weak profitability remains problematic. In spite of important monetary policy measures and public sector guarantees on bank loans, bank stock prices fell markedly in recent period. Some banks are traded at 20 or 30 percent of their book values, which is extremely low.

In short to medium term negative demand shocks and deflationary forces will dominate. It will be very difficult to engineer inflation in the upcoming 3 years back to its target. Weak growth, high level of uncertainty, less intensive investment activity, practically stagnating wages and moderate household demand are reducing price dynamics.

On the other hand, inflation risks are not zero in the longer run. Central banks follow very expansionary quantitative easing policies, and there are a lot of supply side disruptions, shortages may develop that may increase price pressure in the long run. Some politicians would like to see higher inflation which would help ease the real burden of the public debt.

According to several market participants, it is very likely that the low interest rate environment will stay with us longer than previously estimated. Do you agree with this statement?

Yes, I fully agree. We will see low rates for a long time. The massive rise in public debt should normally increase market interest rates via the higher supply of government bonds.

Nevertheless, inflation figures will be very moderated. Therefore, central banks can maintain their asset purchase programs and can lower interest rates as low and as long as possible.

A lower interest rate environment can facilitate the service of public debt and can make debt trajectories sustainable.

Inflation won’t be a problem in near term, however, after economies normalize, which would take around 2-3 years, inflation outlook will have to be re-evaluated.

In the long run, do you believe that reforming the tax system - such as reducing taxes on labor and increasing taxes on consumption - in the euro area could help? In the last decade, similar tax reforms have been implemented in Hungary, as a result employment has increased significantly along with the dynamic expansion of consumption.

I agree with that. Taxes on labor must be decreased to support higher employment. Without reducing taxes on labor the previously seen employment levels across Europe are difficult to achieve quickly.

One has to think to improve taxation and find sources for such tax rate cuts. Indeed, tax reforms are a very big topic nowadays.

There is also another aspect that I would like to mention. It is the tax treatment of debt compared to the tax treatment of equity. Taxes are very favorable for those who have high level of debt but for equity the taxation regime is much less attractive. In my opinion it is a big problem in many European countries. There are too much debt and too less equity in the balance sheet of households and corporations. This can be largely explained by inadequate tax incentives.

Do you think peripheral states – like Italy, Greece or Spain - have enough room for fiscal stimulus measures given their high debt to GDP ratios?

Countries like Italy, Greece or Spain are very much hit by the COVID-19 shock. Their tourism industry is suffering greatly. The high level of public debt of these countries is not favorable. The situation is especially challenging for Italy, where debt to GDP ratio is one of the highest in the European Union.

Thus, the ECB launched its pandemic emergency program to reduce the volatility of spreads. The European Central Bank is buying public debt in countries where local bond markets are under extreme pressure.

The question of European solidarity will be key for peripheral countries and the integrity of the European Union. Solidarity is especially important for Italy where potential growth rate will be between 0 and 1 percent with modest inflation outlook. By contrast, interest rates are currently too high in Italy. The cost of debt service should be minimized to make the debt trajectory sustainable.

In addition to the steps taken by the central banks, what kind of fiscal support is needed according to your opinion?

This depends on the length of the epidemic and the resilience of the economy. Basically, two sort of support is needed. One is from the budget directly via the automatic stabilizers, including social security. The other category includes discretionary measures.

The guarantees that the government gave on bank loans to non-financial corporations has also vital importance. The commitment regarding these guarantees differ in countries just like their budget impact. If default rates increase and the guarantees will be activated we can possible see double-digit growth in budget deficits.

Central banks try to keep monetary conditions very supportive to enhance fiscal room and lower financing costs. The yields of 10 year government bonds in Germany are navigating around -0,5 percent. Meanwhile in some countries 10 year yields are at levels which are too high in the present environment. Therefore, the ECB Pandemic Emergency Program decided recently.