Bank of Lithuania
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Interview with Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania, with Mário Blaščák. The interview was published on 1 February 2024. 

1. Your comment on ECB interest rate expectations hit the wires recently with you saying the rate cut may begin around summer. Is it still valid and why?

I look into potential rate cuts from a probability perspective rather than making statements of certainty because the time for real decisions is still to come, and only then will we see and evaluate real data at hand. Having said that, for now, one rationale behind the expectation that you mention is largely rooted in the current inflation outlook, underlying inflation developments and monetary policy transmission. On the one hand, we have observed easing in inflationary pressures and witnessed monetary policy transmission that is likely to dampen inflation in the near term. On the other hand, wage growth and domestic inflation remain strong, and we are still above our inflation target.

The decision to adjust interest rates will be closely aligned with our primary objective of maintaining price stability and achieving our inflation target of  2% over the medium term. It’s crucial to understand that such decisions are data-dependent and made in response to a wide range of economic indicators at the time of making them, including wage growth, consumer spending, and broader economic activity. Therefore, we cannot pre-commit to any specific date when we are talking about rate cuts, and we must remain flexible. The last few years have shown that the economic landscape can change very quickly and unexpectedly, so we have to be ready to react.

2.You also said you are far less optimistic than markets on rate cuts, what exactly do you mean by that?

My comment about being less optimistic than markets on rate cuts comes from a cautious and measured approach to monetary policy adjustments. The markets priced early and sharp rate cuts. It’s crucial to emphasise that, although we pay attention to market pricings, our decisions are grounded in a comprehensive analysis of economic data and forecasts, ensuring that inflation would converge towards our 2% target in the medium term.

Here I can also note that market pricing over recent weeks has become more aligned with my views. Market expectations about a rate cut in March have declined, which for now seems a premature date for a rate cut – but our task is not to fight market views. We are aiming to provide clarity on our reaction function and expected inflation dynamics. If economic and inflationary developments require rate cuts that would be in line with market expectations, we will not hesitate to act.

3. In your last interview for HN back in September 2023 you used the analogy of „chopping the head off the demon of inflation“ in the context that with chopping one head, the other may arise. In light of current geopolitical tension in the Middle East do you consider the upward pressure on oil prices to be „the other head of the demon“?

The economic landscape is full of surprises and is constantly evolving. Indeed, if one head of the demon is chopped off, another might arise. It is impossible to fully anticipate what will happen, but we try to gather as much evidence from different sources as possible when we undertake monetary policy decisions in the Governing Council.

The ECB’s most recent monetary policy statement of 25 January identified geopolitical tensions, particularly in the Middle East, as one of the key upside inflation risks, together with wage growth. We are carefully analysing energy price dynamics, both in the spot and futures markets. In addition, we attentively monitor the dynamics of freight and transportation costs as well as overall global trade. We have had bitter experiences of how these energy and transportation cost shocks can lead to second-round effects.

All of this information will eventually end up in our projections. At the beginning of March, we will see whether these inflationary pressures will outweigh the overall disinflationary forces that we have observed in recent months. For now, this upside shock seems to have had a rather muted impact on overall production costs, particularly when demand is rather weak and inflation expectations are contained. However, if these upward pressures in energy and transportation costs escalate further, this would of course be a negative sign for the short-term inflationary dynamics. The main question for us, though, is how this would impact inflation in the medium term. That’s a question that we will have to answer in our March meeting.

4. Both Suez and Panama canals face serious traffic disruptions. How serious is this problem for inflation outlook?

The disruptions in the Suez and Panama canals led to a relatively small increase in shipping costs and delivery delays comparing to those observed in 2021 and 2022. This could be explained by currently lower global demand growth for goods, lower port congestion and higher shipping capacity. The effect of the attacks in the Red Sea on oil prices has so far been limited. However, as I mentioned earlier, an escalation of the Middle East conflict could pose upside risks to oil prices and eventually to inflation.

Overall, shipping disruptions pose upward risks to inflation, and we follow these developments very closely.

5. The ECB is closely monitoring the wage growth in the Eurozone as one of the key determinants of inflation. What is your view on current trends in this field?

Wage dynamics play a critical role in shaping the medium-term inflation outlook, and thus should be carefully considered in determining our monetary policy stance. We are currently observing compensation per employee growing at an annual rate exceeding 5%. This increase is understandable, as workers seek to recover some of the purchasing power eroded by high inflation. However, this also contributes to domestic inflationary pressures. At the same time, we see that lower unit profits have started to mitigate the inflationary effects of wage increases.

In addition, we closely follow a timelier wage tracker, which shows that wage growth is still strong. However, wage growth in the latest agreements suggests that pressures have already started to ease. We anticipate a gradual deceleration in wage growth throughout 2024. The upcoming renegotiation of a significant portion of labour contracts in the euro area by the end of March 2024 will provide early indications as to whether this forecast holds.

6. Inflation in the Eurozone looked subdued by the 2023-year end, but with the basis effect fading, we might see rebounds in the rate of inflation. Does this deter your inflation outlook to settle below target only by the end of 2025?

Our aim is to achieve the 2% medium-term inflation target. We have seen an uptick in the inflation rate in December, which was driven primarily by energy base effects. Headline inflation is affected by various one-off factors, such as the end of energy subsidies, but this should not cloud our overall assessment. These short-term fluctuations matter if they affect inflation over the medium term.

It is worth reminding us that we still have core inflation well above our target. Inflation over the medium term – and in 2025 – will mainly be driven by wage growth. For now, it seems quite likely that we will sustainably reach our target in 2025. However, this depends crucially on the trends in the labour market. 

7. Does the ECB take the government funding costs into consideration while deciding on monetary policy?

We do not base our decisions on changes in government bond yields in the market. What we actually do is incorporate various market indicators in our projections, including short-term and long-term yields. For instance, the increase in government bond yields might act as a restrictive measure for the economy, as this usually raises the required rate of return in the private sector and thus restricts willingness to invest and spend. The opposite effects emerge when yield decreases, so the key focus for us is the broader economic and financial conditions in the euro area. We conduct our monetary policy independently and do not target government funding costs.

8. What is the optimal scenario for the interest rate development in the Eurozone for 2024 from your point of view?

I think the optimal scenario depends on various factors, and it is hard to know in advance what is optimal. Monetary policy decisions affect inflation, and trends in inflation affect monetary policy. Shocks such as increases in geopolitical tensions might also affect inflation and, in turn, monetary policy, so we should remain humble and base our decisions on incoming data. Given the data we do have at this juncture, as I have said before, the further we go into 2024, the greater the chance of rate cuts.