Eurozone: very low interest rates for how long?

• Danish monetary policy is closely linked to ECB policy so the recent statement of Denmark’s central bank governor that he expects interest rates to remain around current negative levels in the next five to ten years is not without importance for the eurozone
• Forward guidance by ECB implies that policy will only be adjusted when justified by economic conditions. The inability to be clearer in terms of time frame illustrates the complexities of inflation dynamics
• Past wage increases will gradually filter through in a pick-up in inflation although low inflation, well-anchored inflation expectations and intense competition in certain sectors may very well moderate this transmission
• It thus seems clear that the current policy will remain in place for a considerable time. How long ’considerable’ turns out to be will depend on the data. The eurozone clearly needs more growth.

For how long will ECB policy rates stay at their current level? Recent statements by Scandinavian central banks have, indirectly, shed some light on this. According to Reuters, “Denmark’s central bank governor Lars Rohde expects interest rates to remain around current negative levels in the next five to 10 years.”i Considering that Danish monetary policy is closely linked to ECB policy, it is tempting to consider this statement as an implicit projection for eurozone policy rates. His Swedish counterpart at the Riksbank, on the other hand, has flagged that, despite a slowing economy, the executive board will most probably raise the repo rate from -0.25% to 0% at its meeting on 19 December.

According to governor Stefan Ingves, negative rates have worked well “but it is a completely different conversation what happens in an economy if you stick to negative rates for a long, long time period.”ii This suggests that the planned repo rate hike is inspired by concerns about possible unintended consequences of a prolonged negative rate, an issue which is most relevant for the eurozone as well. However, such a move should not be considered as the start of a tightening cycle. According to the governor, considering the very uncertain outlook for economic activity and inflation, it is “difficult to say, at present, when it will be appropriate to raise the repo rate next time.”iii This difficulty also underpins the data-dependent forward guidance by the Federal Reserve (which implies that rates are on hold as long as there is no material reassessment of the growth and inflation outlook) as well as the ECB’s state-dependent forward guidance (which requires a robust convergence of inflation to a level close to but below 2%).

This guidance implies that policy will be adjusted when justified by economic conditions but the reluctance, or should one say inability, of major central banks to be clearer in terms of time frame illustrates the complexities of inflation dynamics. These can be represented as a trickle-down process whereby 1) strong demand on a sustained basis 2) creates bottlenecks in the labour market, which 3) causes an increase in wages and, 4) despite increases in productivity, a pick-up in unit labour costs. Strong demand for goods and services may very well reduce the price elasticity of demand, thereby 5) enabling companies to raise their prices so as to shield their profit margins from higher wage costs. This sequential process takes time as the economy moves through the different phases. In the current cycle, eurozone wage growth eventually accelerated, even significantly in some countries, in conjunction with a decline in the unemployment rate and the emergence of labour market bottlenecks. The real issue is the transmission of higher wages into higher inflation, which has been until now very limited.

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