Interview with Athanasios Orphanides, Governor of the Central Bank of Cyprus, conducted on 15 November 2009 by Michelle Kambas and Sakari Suoninen
Q. How do you see inflation developments going forward? Do you think the ECB in general is paying too little attention to core inflation?
In assessing the outlook for inflation we look at everything, including both headline and core inflation. The first thing I should point out is that to a large extent the negative readings in inflation in the recent months reflect the drop in energy prices from the highs of last year. Going forward, I expect a return to positive readings and then a gradual increase in headline inflation. Core inflation is particularly useful to monitor in circumstances like the ones we have experienced over the last couple of years, when we have had a rather dramatic and unusual swing in energy prices, because core inflation does not reflect these swings. For this reason it is less volatile and useful to look at in current circumstances. The October ECB Bulletin had an informative analysis of recent trends in core HICP.
In my view, it was reassuring to see that inflation excluding food and energy prices remained broadly in line with the ECB's definition of price stability despite the rapid increase in oil prices we had a couple of years ago. But over the past year or so, core inflation has been trending down, and away from the ECB's definition of price stability of HICP inflation close to, but below, 2 percent. Core inflation has not stayed as stable as might have been desirable, reflecting in part the weakness in economic activity associated with the financial crisis.
Q. Are you concerned that the ECB might undershoot the inflation target in the medium term? If you look at the Survey of Professional Forecasters, it shows 1.6 percent in 2011, clearly below the definition of price stability, and also the European Commission forecasts 1.5 percent.
There are two things that I believe are useful to look at regarding survey responses on inflation expectations. In the most recent Survey of Professional Forecasters (SPF), the most important is the evidence confirming how well-anchored inflation expectations are in the euro area in the medium to longer term. The stability of inflation expectations, as indicated by the five-year horizon in this particular survey, is very helpful for our monetary policy strategy. Well-anchored inflation expectations give flexibility to monetary policymakers to respond to unexpected shocks and other disturbances, without having to be concerned about persistent deviations from price stability.
That said, you are right to point out that HICP inflation expectations for 2011 -- the year-after-next inflation expectations in the current survey -- are rather low. Indeed, the reading for the year-after-next inflation expectations, which has stood at 1.6 percent in both of the last two surveys, is the lowest year-after-next reading we have seen in the history of the SPF. Given that our definition of price stability is HICP inflation close to but below 2 percent, I would have preferred inflation expectations for that horizon to be more in line with the earlier history of the survey.
Q. Does that suggest that ECB policy has been too restrictive?
The low inflation expectations at the policy relevant horizon can reassure us that the current very accommodative stance is indeed appropriate, as the Governing Council has suggested over the past several months.
Q. Do you then think that had the ECB lowered rates further the impact for the economy would have been larger?
In assessing the stance of monetary policy in the current environment, in my view it is important to look at the whole monetary policy package and not just focus on the policy rates of the ECB. As is well understood, when short-term nominal interest rates are very close to zero, which are unusual circumstances for central bankers, other measures -- non-standard, unconventional policy measures -- can also be used in order to provide additional monetary policy impetus when that is needed. The ECB's decisions over the past year have indeed utilised appropriately non-standard measures. Let me remind you that since May, in particular, the provision of unlimited liquidity with appropriate collateral at maturities of 3 months, 6 months and even one year is very, very unusual.
Q. Regarding the outlook for economic growth. We now have the SPF and the European Commission forecasts which expect 1.0 and 0.7 percent next year respectively, and then about 1.5 for 2011. Do you think that they are reasonable?
Regarding the euro area growth prospects, I would say that following the significant and protracted drop in real GDP that we have seen over the past year, the increase in real GDP for the third quarter is a very welcome confirmation that the euro area economy is on the way to recovery. This is the recovery that I see embedded to varying degree in several forecasts.
Although we have this welcome confirmation that the euro area economy is on the way to recovery, we should keep in mind that recovery could well be bumpy and that uncertainty remains unusually high. The deleveraging process of the euro area banking sector continues and credit growth remains unusually weak at the moment, suggesting some ongoing strains in financing conditions. While on the one hand I believe we can be cautiously optimistic regarding the outlook, on the other hand we need to remain alert about the evolution of the economy.
Q.Do you think this recovery we are seeing now is sustainable or, when do you see sustainable recovery that is not dependent on stimulus measures?
To some extent, the growth we have seen in the third quarter is the result of temporary stimulus measures. But, overall, the prospects for the euro area economy are brighter than they were a few months ago so I believe that is a cause for optimism.
Q. You said there is some evidence from the lending data suggesting there are strains in the financial system. Do you think there is a danger of a credit crunch in the euro zone?
It is very difficult under the circumstances we have been experiencing over the last year to distinguish clearly between a drop in the supply of credit and a drop in the demand of credit. Without doing that, it 's hard to assess whether we are experiencing a credit crunch or not. My reading of the data and also of the information from the bank lending survey is that to a large extent we have seen a substantial fall in the demand for credit. To the extent that the considerable reduction in credit growth reflects a reduction in the demand for credit, it should not be read as evidence of a credit crunch. I think the decisive measures that have been taken both by governments in the euro area on the fiscal side and by the ECB on the monetary side have averted the worst consequences that could have been experienced as a result of the crisis and have allowed credit to continue to flow into our economy.
Q. According to the Reuters poll, and this has just been changed back, the expectation of an ECB rate rise has been either in Q3 or Q4 next year. Do you think there might be a need to raise rates sooner than analysts expect?
We never precommit and we always monitor carefully incoming data and information in taking monetary policy decisions. Indeed, I personally find discussions about policy guidance regarding interest rates well into the future unhelpful, precisely because so much depends on the information we will be receiving in the mean time.
The key, I believe, is to understand our mandate and policy strategy.
If the economy surprises us on the positive side with strong growth and higher inflation, then the removal of the current policy accommodations will have to occur faster.
On the other hand, if the recovery stalls, one can never exclude that policy should remain accommodating, as is necessary, always to ensure that in a forward looking manner inflation will be in line with our definition of price stability.
Q. The SPF forecast for 2011 sees the GDP growth of 1.6 at the same time it sees HICP inflation undershooting the ECB’s target. Are there special reasons why there could be non-inflationary growth?
In general, one could not expect there would be inflationary pressures in the economy while economic growth remains below the economy's potential for economic growth. Here, one of the big unknowns is the economy's long-term growth potential and how this may have been affected by the crisis we have been experiencing over the past year. If I were to get some hints from the SPF, the long-term growth potential that is suggested by the five-year-ahead growth forecast is around 1.9 percent. When you refer to expected growth in the survey of 1.6 percent for 2011, that is still below what the survey respondents suggest is the long-term growth potential for the euro area economy. Under these circumstances, it would be less likely that the economy would face inflationary pressures and more likely that the economy would face disinflationary pressures. But we cannot exclude that the growth potential is lower at present.
Q. Regarding liquidity measures. Would you see adding a spread to the December 12-month refi as justified?
We will make a decision regarding the 12-month LTRO in our next policy meeting. I do not want to pre-empt that discussion.
Q. How do you see the market conditions?
Market conditions have clearly improved. We can see this in various ways. One of the reassuring developments that we can observe is the continued decline in the euribor rates at various maturities. The three, six and 12 months maturities, have come down as we had expected. I read this as a welcome development of improved liquidity conditions that confirms that the extraordinary measures that the ECB has taken have succeeded in alleviating the extreme strains we experienced late last year and this spring.
Indeed, looking at the improved market conditions means that when we look ahead into 2010, not all our liquidity measures will be needed to the same extent as this year -- and this was stated by the President in the introductory statement last week.
In this light it may be deemed appropriate to reduce the frequency of some operations and perhaps change the terms of some others. This is with regard to the influence of the measures we have taken on the liquidity conditions.
At the same time, as I have explained on previous occasions, when short term nominal interest rates are close to zero, unconventional measures may serve the purpose of engineering additional monetary policy easing beyond what is associated with changes in policy rates under normal circumstances. Indeed, the full allotment operations at fixed rates and at maturities that are longer than our normal monetary policy operations have succeeded in providing this additional easing in monetary conditions over the past many months.
Q. Do you think there is a need then to keep going with the full allotment at fixed rate policy?
I try to look at the two major influences of unconventional measures that we have had, one being the provision of liquidity, the other being the influence on monetary policy conditions.
Conceptually, I find it useful to think about these two because phasing out some non-standard policy measures that may no longer be needed in light of improved market conditions is not equivalent to a monetary policy tightening.
When I’m thinking about the appropriate stance of monetary policy in the current circumstances, I view non-standard measures as part of the policy package that defines the degree of accommodation in our policy.
Discontinuation of all of our non-standard measures would represent a tightening of monetary conditions. So if we think about it in these terms, the associated decisions would have to be governed by considerations similar to those determining a conventional policy tightening, which brings us back to the discussion we had earlier of the outlook for inflation in the euro area.
Q. When the ECB speaks of ensuring price stability on the medium term, how long is that time? Is it shorter in times of boom and bust than it is during regular growth, as some have suggested?
An unexpected shock such as the rapid rise in energy prices that we experienced a couple of years ago or the global financial crisis that we experienced over the past year, can push, and indeed has done this, inflation above our aim, as occurred in 2008, or below our aim, as is happening this year. In the circumstances, monetary policy must be set in a forward looking manner to counteract these unwelcome developments. In my view, we should pursue this objective in a symmetric manner, striving to avoid both inflation being too high, that is veering above 2 percent as measured by the HICP, as well as inflation being too low, that is staying significantly below 2 percent for too long. Failing to pursue an appropriate policy to this end, risks dislodging inflation expectations which in term can complicate our ability to secure price stability in the euro area.
Q. On Cyprus: We had data on Friday indicating a 1.4 percent contraction in GDP, quarter on quarter. Do you see European Commission forecasts of a contraction by 0.7 percent this year as reasonable?
The most recent GDP data for the third quarter for the Cypriot economy are indeed an unwelcome negative development. They seem to point to a deterioration in the Cypriot economy that is larger than what we had anticipated in the past.
Q. Do you think the concerns about Cyprus possibly entering an excessive deficit procedure with the European Union are well founded?
The European Commission published its Autumn forecasts last week. What I found most worrisome was the Commission’s forecast for an increase in the deficit from 5 Ύ in 2010 to almost 6 percent in 2011. With deficit projections like these it is a foregone conclusion that Cyprus cannot avoid the excessive deficit procedure.
I only see this as a matter of timing, but I think it’s a foregone conclusion that we cannot avoid it.
It is also noteworthy that the Commission projects this substantial deterioration in the deficit together with a return to growth, especially for 2011. This does suggest that structural changes will need to be made to put our economy back onto a path of long -term sustainability.
Q. Regarding the reunification talks, there has been a lot of talk about merging the two economies. What are the guiding principles which should be upheld in the context of a settlement? Does the adoption of the euro help?
I strongly believe that a unified economy gives tremendous growth potential for the island.
It would greatly facilitate both the economic convergence that we could have -- I believe fairly rapidly -- and successful reunification. It would also create wealth that could be sorely needed in order to finance some of the aspects of reunification that we may face ahead.
I believe we can achieve fairly rapid economic convergence, if in the context of reunification we avoid the trap of creating barriers that would not allow us to unify the economy effectively.
The fewer barriers we have in the context of a unified economy, the easier it will be to achieve a rapid convergence process and generate wealth for all citizens of the island.
I believe our entry into the euro area is a factor that should be helpful in resolving a number of questions that were open in the past.
Before we entered the European Union and the euro area there were a number of questions on what the currency should be, what the structure of the Central Bank should be and so forth.
Being in the European Union and even more so in the euro area eliminates many of these issues and areas of potential disagreement because we need to abide by the rules governing the single economy in which we now operate.