Philip Lane on the Big Problems Facing the Euro-zone Economy

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1:13Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Weisenthal. Joe, did you see last month the European Commission released a competitiveness compass with a bunch of recommendations for how to boost productivity in the eurozone? I missed that. However, I know that there have been a number of sort of similar reports and studies. Mario Draghi, I think the former ECB chief last year, put out this big thing. There's certainly been a source of debate, consternation, anxiety, so forth. So Mario Draghi's competitiveness report was 400 pages and the European Commission one was 27 pages.

1:54And I can't figure out whether or not that makes the commission more productive than Draghi or less. Like their output is physically smaller, but maybe it's more efficient and succinct. You're absolutely right. This is kind of a tough spot for the eurozone. So growth has been slowing while inflation is still kind of sticky. In fact, we had EU inflation for January recently, and it came in slightly hotter than expected. I think it was something like 2.5 percent. And Europe's been dealing with an energy crisis, plus now the threat of tariffs emanating from the Trump administration. And against all of those sort of short term immediate challenges, kind of hovering in the background is the sense that Europe is falling behind in key technologies like AI, that it's becoming less competitive, less productive relative to other places.

2:46Right. And it's sort of implicit in what you're saying here. But the other big key source of anxiety is just the sort of core industrial superpowers and their competitiveness, particular vis-a-vis China. And I'm thinking about oil, perhaps the chemical industry and so forth. And then, you know, you layer onto it, as you already mentioned, the possibility of tariffs and the future of trade with the United States specifically. There's a lot going on. Yeah, all of this is a very long winded way of saying that Europe is facing both cyclical and structural problems or challenges. So I am very happy to say we have the perfect guest to discuss all of this.

3:27We're going to be speaking with Philip Lane, the chief economist over at the European Central Bank. So, Philip, thank you so much for coming on All Thoughts. Good morning. It's great to be here. Why don't we start with the thing that is all over the news, which would be tariffs? Joe and I personally are kind of struggling to cover these because the headlines change so fast by the time we get a podcast out. Like the news on trade restrictions has already changed. How does the ECB factor potential tariffs into its monetary policy? Because your forecast right now, I don't think they actually take tariffs into account, but we know that Trump has talked about imposing tariffs on the EU at some point.

4:13So let me make two differentiations there. Number one, of course, for a long time now, there has been speculation about tariffs. So to the extent the speculation about tariffs is feeding into investor plans, consumer plans, it's there in the data. And as you said, a lot of the sentiment indices are kind of subdued. And I think clearly the uncertainty about trade is one of those factors. What is true, though, is we have looked in great detail about different tariff scenarios. But until you really know the scope of what we're talking about, putting those into the baseline we haven't done, we will essentially adjust when and if we see more detail.

4:58And of course, this can evolve. The trade policy configuration we have in spring 2025 may not be the trade policy configuration we have in the autumn or next year. So I don't think it's kind of a zero one, one day only type event. It's something we will continually reassess. Setting aside, obviously, there's a lot of uncertainty. We don't know. 10 percent, 25 percent, 0 percent. We don't know. But how do you think about tariffs? Because, you know, you hear two different things when it comes to tariffs and cyclical policy. One is, OK, maybe you get some sort of like price shock or something like that.

5:37And maybe that's inflationary. Maybe that's not. But then also the implication is that tariffs force a longer term adjustment and perhaps countries have to invest more to be more self-sufficient, et cetera. When you think about the Eurozone's trading position today, what are the vulnerabilities and how would you think about the sort of macro effects of how tariffs play out? I don't think there's any question in terms of output. The effect of introducing frictions into the global trading system is a negative. So it has to be bad for output. Now, there will be mitigants. As you say, firms will work out, OK, now I'm going to find another supplier.

6:19Now I'm going to build another plant somewhere else to kind of get around tariffs. But those are mitigants. They're not going to say, well, all of a sudden, that's a net positive. So I think there's no doubt it's net negative for output. As you say, for inflation, there's many conjectures that, of course, mechanically, if it turns out to be the case that there's more expensive imports from America. Mechanically, there's an upward effect from that. On the other hand, as we just talked about, if there's kind of a weakening of domestic demand in Europe, if there's a lot of trade frictions globally, if there's a weakening in the global economy, those are disinflationary forces.

6:59So in December, we basically, and now again in our January meeting, we said for output, it's a downside scenario. For inflation, the effects are uncertain. But as you indicated earlier on, there's also classic issues about price level versus inflation, how big this is compared to all the other factors we have to think about for inflation. So I would say, you know, I think it's very natural to focus on the economic effects. And then we will look at the inflation effects as we see it unfold, rather than taking a very strong ex-ante position on that. Hmm. I'm going to ask a very broad question, but European growth has kind of been flatlining.

7:41And at the same time, we had that inflation number recently coming in slightly hotter than expected. How would you characterize the EU economy right now? So I think what you have to go back to is 2022. So 22, on the one side, we were coming out of the pandemic. There was a burst of activity as we reopened. And remember, Europe had a much longer lockdown than over here. But then we had the Russia-Ukraine war in spring 22. So after that, we had inflation going all the way to 10.6 % in October 22. And of course, we had to respond to that by raising rates, which were in a low for long before then.

8:23So our policy rates went from minus 0.5 to plus 400 in terms of basis points. So there's a lot of adjustment. What that meant is in 2023, we did flatline. In 2023, Q4, the year area economy grew by 0.1. Now, if I look at last year, 24, there was a partial recovery. We went from 0.1 in 23 to 0.9 in 24. And that we expected that we expected consumption to recover in particular. Now, it wasn't as strong as we would like. Then we have, as we just talked about, new types of shocks hitting the economy. But let me emphasize is that we do think, going back to this cyclical structural issue you raised, that there is cyclical recovery as our baseline.

9:10We should expect to grow probably a bit above potential this year and next year. And essentially, if you think about it, a lot of factors are kicking in. As we ease monetary policy, we still expect this year to be led by consumption. And then in 26, more than this year, a recovery in investment. And then also, I think, a contribution from exports. So I think it's important, you know, if you kind of are too backward looking about this, you're looking at maybe the stagnation of 23, or you are looking, in fairness, at the Q4, which did flatline a bit. But I think there's some cyclical factors in those Q4 data.

9:52On inflation, we're down from 10.6 in October 22 to 2.5 in the most recent number. That's, by the way, I know there was some market speculation, was that a bit high. From my point of view, what's been developing is a bit more energy inflation, but actually services inflation, which has been what we've been really looking at, came in softer than I would have expected. So it's not the case. The overall inflation profile is too dramatic. And what we think is fairly soon, we will be back at our 2 % target. And essentially, that's why we cut rates last week. The market is still pricing in several more rate cuts for 2025.

10:34I take your point about the salience of services inflation. And obviously, you know, it's very common for central bankers to sort of recognize that there's always so much you can do about the energy price component. But given where inflation is and given what you describe as a cyclical recovery and likely further impulse, does it make sense to still be cutting into that environment or at that depth? Well, I think we're trying to be cautious. So one of our kind of stable sentences is no preset pass. So even if the market is probably seeing several cuts, I'm not saying there's any reason not to have that market view.

11:17From a policy point of view, our emphasis is really on agility. The energy situation is changing. It may change again in either direction in the coming weeks. And I say we have a balancing act. We do have the recovery, but we also know that essentially the disinflation is well on track. And as disinflation continues, finding, if you like, the new normal for interest rates is essentially a part of our challenge. And when we cut last week from 300 basis points to 275, that was essentially saying, well, 300 is not the new normal. And I think we'll be in that search process as we go along. Since you brought up the new normal, I mean, one thing the U.S.

12:02and Europe do have in common right now is this debate over the neutral rate. So R-star. How useful is that idea when it comes to setting interest rates? And also, when you look at the economy right now, how restrictive do you think rates actually are? I think it's important to have narrative frameworks. And one of the narrative frameworks is when inflation is well above 2%, it's very important that everyone understands that monetary policy is going to be restrictive. and that's important to be able to demonstrate that the policy rate is higher than so-called normal. It's important to look at is demand dampening, i.e.

12:45is the pricing environment making it more difficult for firms to be able to get through price increases. As inflation comes back to more or less around target, those factors lose kind of resonance and you do have to kind of change the narrative framework. Now, what we said in December, and I think this is maybe not rocket science, but maybe it's helpful is what we're going to do is we're going to set monetary policy appropriately. Now, the appropriate phrase is essentially saying, what do we need to do to keep inflation around two? And this is where the neutrality debate loses some relevance. You know, what is the probability in the next number of months, the world is neutral, so there's no shocks.

13:29Mm-hmm. So it's a nice hypothetical conjecture. But if you are more dealing with shocks, so whether downside shocks or upside shocks, monetary policy has to, if they're material, so they're there for the medium term, not just noise. So I think now as you get closer to that zone, let's not talk about neutrality. Let's talk about what's appropriate. And then you do the standard wish list. You know, are we seeing, what are we seeing in the pricing data? What are we seeing in the activity data? what are we seeing in the transmission? Because again, we have a bank-based system over here in America, much more market-based system.

14:10I mean, the markets, of course, matter in Europe, but we pay a lot of attention to banks. And right now, to one of the dimensions of the question is what we see is credit starting to pick up. So there is some easing there, but it's still very subdued, still well below historical averages. So what I would say is compared to the peak, there's been some easing, but it's not the case that that process has gone into a kind of new steady state. We're still in a recovery phase.

14:56Your best restaurant location gets five-star reviews. How do you make every location like your best location? Your best paper mill has been operating at peak productivity. How do you make every mill like your best mill? Your best data center has optimized every drop of water. How do you make every data center like your best data center? The answer is Ecolab. Better performance, better outcomes, better impact. Ecolab. Now every location is your best location. How many vendors does it take to meet all your organization's food needs? Just one. EasyCater, the workplace food platform that lets teams order from a huge variety of restaurants, over 100 ,000 nationwide, all through a single vendor.

15:41In addition to all that variety, EasyCater also gives you full visibility of your organization's food spend with invoicing, centralized reporting, and seamless integration with expense management systems, all on one platform. Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. I want to ask you a question that I've actually asked several policymakers in the U.S. about the last several years. The nature of inflation in the U.S. and in the Eurozone, some similarities, some differences. The spike of the Eurozone was probably more pronounced a bit thanks to the energy shock specifically.

16:21But, you know, obviously there is a sort of like cyclical component and then an energy specific component. What's interesting to me, setting aside energy, unemployment in the eurozone, if I'm looking at this correctly, is actually like at a multi-year low right now. Lower than it was at the peak in 2022. What is your story for if we think of central banking as sort of working through this unemployment or employment activity, inflation tradeoff? What is your employment for why the sort of core measures of inflation or services inflation have eased so much, even at a time of what seems to be labor market tightness, no easing at all?

17:01So I think the labor market tightness is part of it. And actually, the year area is an interesting place to look at that, because, of course, across the year area, you have some economies that are hotter than others. You have kind of a laboratory. So absolutely, there is a correlation between a tight labor market and wages. But the strength of that effect is not big compared to the size of the inflation shock we had, which was essentially an intersection of two factors. One was the energy shock and two was the exit from the pandemic. So more or less exactly at the same time in spring 22, we had the Russian invasion of Ukraine.

17:46And that wasn't just a kind of a level shift in energy. From there until August 22, you just really large, extreme run up in gas prices. But in the same six months, so spring to autumn 22, this is when the European economy reopened. So actually, if you look at activity data, it's quite strong for those six months because tourism restarted, hospitality restarted. So this is a very unusual configuration of events. That reopening had a demand element to it because, of course, people really wanted to spend. And of course, the supply was still pandemic constrained. So this, I would say, is weird, unusual, not representative.

18:32So I'm not that surprised implementing the most basic macro model only gets you so far. And then if you like compared since then, and I think that's common across the US and Europe, is a lot of what's happened is the supply side has recovered. The exact nature of it on both sides of the Atlantic is there. And that recovering the supply side is essentially why you are able to have disinflation and recovery in the economy. And as you say, we do have the lowest unemployment in the history of the U.A. Again, let me come back to this differences across the U.A. Germany has been suffering. We know that unemployment has gone up in Germany.

19:13So the labor market is what you would expect. Spain has been very strong. Unemployment is coming down in Spain. And so when you think about the overall U.A. narrative, I mean, when you talk about the U.S. economy, we all tend to think about the U.S. in the aggregate. But of course, there's differences across California, Chicago, New York, and so on. Same for us. There are big differences right now across some of the major countries. You touched on this earlier, but could you talk a little bit more about the transmission mechanism of lower rates and how those actually feed into the economy? And perhaps more importantly, how long they actually take to take effect.

19:55So in the U.S., we hear the Federal Reserve talk a lot about long and variable lags, which gives them quite a lot of wiggle room to argue whether or not hikes or cuts are actually having an effect. How do you think about the transmission mechanism and the time frame for changes in policy to take effect? So, I mean, this is what keeps us busy. And this is why throughout this period, some people don't like these phrases, but they're essential. We said we're going to be data dependent. And we said we have this reaction function where essentially as we see the transmission in action, we can recalibrate our policy.

20:33So let me maybe explain why it's the complexity in the area. We were in a low for long environment, even in December 21, when already inflation was picked up. The markets believed the policy rate would not go above zero until around 2027. So there's high conviction that we were in this low for long period. This is my favorite chart, the hairy charts. The Medusa charts. Yeah, the Medusa charts of market expectations of rates, and they're always, always off. Well, I mean, the world changes. Then we had this fairly rapid hiking cycle to 4%. And now we're coming down from that. And then the market is debating somewhere in the neighborhood of 2%, let's say, is the new steady state.

21:21So in terms of how people think about the financial system, some of it is, well, we're going from an old steady state of basically at the floor. The new steady state is around 2%. And how do I value assets? How do I organize my saving, my investment around that? So on top of the cyclical issue of as we ease rates, but we're easing from 400 in the neighborhood of 2%. We're not going back to the pre-shock super low rate. I mean, we don't expect to. So that's an additional factor in transmission. Let me emphasize a couple of things. One is about the bank-based system. And then one is how the economy responds.

22:08So in a bank-based system, and we had new numbers this morning, essentially because, of course, banks are partly funded by deposits, partly funded by market funding. Deposits, they have responded, but not one-for-one. There's still lots of zero interest overnight deposits funding banks. So the one-for-one transmission of the policy rate, that works in the money market. It's softer, both on their way up and on their way down for the banking system. So we have taken into account in the banking system with a mix of deposit funding and market funding, the transmission is slower. And then on the economic side, one issue we talked about last week was housing investment.

22:52That's the classic interest rate sensitive area. And we are seeing mortgage loans pick up quite a bit in Europe, but we haven't seen housing investment move up yet. And this goes back to, like here to some extent, okay someone's decided i'm going to start a new project getting the permits finding the workers all of that takes time and so this is why i said to you earlier on we think the big recovery investment is going to take a while it's not all going to happen this year in 25 it's going to go into 26 so a long way to summarize where we are is it's multi-year it really is a long lag and And again, from word go, from the time we started hiking, I and the ECB flagged quite a bit.

23:40We haven't done this very often. How much of an evidence base do we have about how long are those lags? How powerful is transmission? And in the context of a pandemic and a war. So for all those reasons, it really goes back to I'm reassured that transmission is working. I see it. But I'm also validated, if you like, that it takes real time. It takes real time before it transmits all the way to the economy. Tracy, I just remembered something. And, you know, you started the episode talking about some of the big structural things which we should get to. Do you remember in the blogosphere in like the 2010s?

24:17I just remember this, the six versus the structs debate. Oh, no, I don't remember that. Some people were like, oh, is the U.S. face like just a cyclical challenge where we need more demand? Or is there a structs thing where we need to like structurally change how the U.S. economy works? Do you remember that? Anyway, it occurs to me like every time there's some big economic shock of any, you get this debate, right? How much is it a cyclical thing where, you know, economies go up and down, inflation goes up and down, unemployment goes up and down versus something structural, deeper with the economy, perhaps which demand policies, whether they be fiscal or monetary, are sort of to some extent insufficient to address them.

24:56And obviously, you know, Tracy mentioned in the beginning, these competitiveness reports and the Draghi report and all that stuff. Do you feel like we're at a moment where it's important for Europe to be thinking about like deep structural issues? Or is it just weird sort of taking our eye off the ball and then in the end, these are still sort of cyclical challenges for the economy? Well, let me make a few points about this, because, of course, this debate is ongoing. First of all, I think it's important to recognize there isn't a clear, bright line between cyclical and structural. because, of course, if an economy faces structural issues, more or less, if you have pessimism on a structural basis, it will lower demand.

25:40So cyclical policy is called for even if the origin is structural. But let me say, on top of all the structural issues, which are global, every country debates how to deal with aging, how to deal with climate change, how to deal with digitalization, AI, and so on. In a European context, maybe there's two extra factors. One is the structure of Europe. That's literally a structural factor. We have choices and debates about essentially more integration, the single market. And as you mentioned earlier on, Tracy, last week, the European Commission announced this competitiveness compass. That's essentially a long to-do list to convert the Draghi report, the letter report, into essentially action.

26:26And of course, you can imagine in a European Union, there's a lot of things need step by step action. So I would say it's all aligned, but it's just we have a new commission. It's basically a kind of an agenda for the next few years. But fundamentally, and this is where the Draghi report starts, is Europe had a very good idea 40 years ago now that essentially in a modern world, scale economies matter. if the European member countries essentially come together and build a single market, that will really help. That remains. And the intersection now is, I think, with digitalization, with other new technologies, scale economies really matter.

27:12It's really hard to think about, okay, if I have a big fixed cost investment, if I build some new AI kind of business model, Rolling that out is a function of scale. So the European Union building scale through a single market, the case for it is now reinforced. So I think there's new energy about that. And then, of course, the other big one, maybe, Joe, just because I think this is interesting from a global point of view, is the global, if you like, equilibrium. One thing the ECB has worked on and identified is essentially when you can do this exercise of comparing economies and what's interesting of the last 15 years is europe and china have become more similar the us has not become more similar so if you think about which industries are important activity the composition of activity and of course this is immediate applications like in the car industry now china is much more similar to europe and with that of course if you think about individual firms who might have been used to certain margins, certain ability to obtain market share, they are under a new competitiveness challenge.

28:25So that is something where Europe is in between China and America. Everyone has their kind of structural priorities. But this issue of how do you not kind of try and build a wall, but how do you navigate this new world is important.