Knot Says Unlikely to See Adverse Shock That Prompts ECB Action

European Central Bank Governing Council member Klaas Knot comments on money-market conditions, the likelihood for policy action and bank recapitalization.

He spoke in an interview yesterday at the World Economic Forum in Davos, Switzerland.

On money-market conditions:

“It is definitely something that warrants close monitoring. What we’re seeing in the money market is actually the flip side of a good development. Confidence is returning to the European banking sector and the euro-zone economy. And as a consequence of that, banks reduce their liquidity buffers. The liquidity surplus, the excess liquidity in the money market, is now being reduced and this is also reflected in the pace of repayment of the VLTROs. Banks apparently come to the judgment that they can afford it to repay the VLTRO and they accept that the liquidity buffer is lower. That’s the good side. The flip side is, of course, that excess liquidity is declining, up to a point where you see more volatility in Eonia. I would like to emphasize that although there is volatility in spot Eonia, if you look at forward Eonia and over longer maturity, there is more stability. Fixed-rate, full-allotment should naturally curb the upward potential for Eonia and its volatility.”

“Why we are seeing volatility is a bit of a puzzle for me because there needs to be a distortion somewhere in the market. Perhaps it simply has to do with imperfect averaging of reserve requirements over the holding period. I don’t have a conclusive answer, I don’t think anybody has. I would argue we would need to understand the drivers better before we could come to a conclusion this would warrant policy action.”

On potential policy response to money-market volatility:

“We distinguish between the monetary stance and the monetary transmission process. If this were to become an issue of the monetary stance, then obviously conventional policy would be the response. If a need was felt to respond, then it would be logical to contemplate further rate cuts in the MRO and in that case also the deposit rate.”

On whether ECB’s balance-sheet review is reason for volatility:

“It could be. The stigma effect might well be a bit higher than normal on central bank funding because of the upcoming Asset Quality Review. If that’s the case, then the good news is that it is a temporary factor.”

On deposit rate:

“We have not discussed such a cut so I couldn’t sort of speak for my colleagues. I would have some concern about narrowing the corridor too much. If the corridor is too narrow, it negatively affects interbank market activity. It leads to a situation where banks have no incentive to borrow from each other. I would favor not narrowing the corridor any further. To my liking, it’s already a bit on the narrow end. Reviving the interbank market is part of the normalization process and we should not impede that process.”

“This concern I already expressed in November. Thus far, the impact on interbank activity from the rate cut has been more muted than I feared but that is not an argument to say we can narrow further. In fact, the argument for not narrowing further has only become stronger.”

On whether more easing is likely:

“If you look at the economic outlook then I totally agree with what our president said only a few days ago. There are encouraging signs but also vulnerabilities. It would need an adverse shock for further action to be taken. At this moment I don’t see such a development. At this moment I actually think that the incoming data confirm our base line projection. If anything, most of the data surprised on the upside recently. There is still a bit of dichotomy between soft indicators and hard data, although hard data like industrial production and retail sales seem to be catching up now. We will have to watch closely in the coming weeks to see whether indeed hard data confirm the soft indicators. But as soon as we would have indications that there is something going on that would negatively impact our medium term outlook to price stability, then obviously that could form a trigger for further action. And as our forward guidance indicates, we stand ready to act. Let there be no doubt about it.”

On inflation:

“Our baseline scenario has monthly inflation readings below 1 percent until May or June. But there is too much emphasis on the monthly inflation readings. This is essentially past inflation. Our mandate is about inflation expectations, about price stability in the medium term. So in essence, inflation readings in the coming months are water under the bridge. In our baseline scenario, inflation is forecast to gradually increase in the second half of the year.”

On deflation risks:

“At the current junction there is obviously a non-zero risk of deflation. But I’m not very worried about it. It is our role as central bankers to keep our heads cool. I don’t want to sound too complacent but our estimates currently are still at very low probabilities for deflation. There are still solid buffers, like current wage developments. Inflation expectations are solidly anchored.”

“Of course, it’s a different question of what happens in certain parts of the euro area. The euro area is going through an adjustment process. It’s logical that a correction is going on in some of the peripheral countries. That correction means inflation has to be lower than the euro-zone average. If the average inflation rate is round 1 percent in the euro area, as it currently is, then I cannot exclude that in some individual spots there is deflation.”

On forward guidance:

“I fully subscribe to it. We will stay low for long and lower if downside risks were to materialize. I think we’re still far away from any scenario in which tightening could already become a policy issue. Take us by our word as expressed in our forward guidance. That’s a very accurate description of where we stand.”

On conditional liquidity operations:

“In designing short-term fire-fighting with unconventional measures we should always keep in mind that they are consistent with our longer term goal of structural adjustment. This minimizes the likelihood that we will ever again end up in such a situation. OMT very strongly embodies this philosophy. If break-up risks were to return, then we stand ready to act only if the sovereign in question is prepared to implement the necessary reforms to avoid ending up in the same situation again. The VLTRO didn’t have this kind of conditionality. It was essentially: Bring the collateral to us and take out the loan. The SMP didn’t have any conditionality either. From SMP we moved to OMT. If ever we have to move from the VLTRO to some renewed liquidity operations, it would seem sensible to apply the same philosophy.”

“As of today, I don’t think funding stress is so acute that something like a VLTRO is on the radar screen. Actually, the monetary policy transmission process, which has been our rationale for engaging in the unconventional policy measures, as of today is much more normalized. Funding conditions are more normalized, term structures have converged significantly if you look at sovereign spreads and longer-term funding costs. So at this moment, the level of impediment to monetary transmission is much lower than a year or two years ago.”

On measures ECB is considering:

“We always want to be prepared. Our thinking never stops. We think about every contingency. I think we’re paid to do that as central bankers. There’s nothing on the table as a concrete proposal. But if the need arises we will be prepared.”

On suspending sterilization of SMP:

“It is one of the options. Every option has its drawbacks. If there was a drawback-free option we would probably already have pulled it. There are clearly also drawbacks to that option such as the public perception around sterilizing SMP purchases. But there are a lot of options in our tool kit.”

On the euro exchange rate:

“A stronger euro makes the life of exporting companies more difficult. It’s a factor that also impacts inflation. A strong euro adds to low inflation at the moment. We have to closely monitor what’s going on in exchange markets because it impacts our primary mandate. At the same time, most comments on the strong euro refer to the euro-dollar rate. If you look at the nominal effective exchange rate, or even the real effective exchange rate and you take the whole period that the euro has been in existence, the current level is in fact not too far away from the average level since 1999. So in that sense the strong euro shouldn’t be overplayed. Obviously, for some exporting countries, a strong euro can be a problem. But a currency devaluation can only offer a temporary relief in terms of competitiveness. If we want to improve competitiveness, then we need to apply structural reforms. That’s the thing that Europe desperately needs. Now that the financial crisis seems to be waning, the biggest risk that I see is complacency in terms of structural reforms that need to take place. Europe has a competitiveness issue but it’s not necessarily an issue that has to do with the level of the exchange rate. It has to do with productivity and efficient allocation of resources. That’s what we need to tackle when we talk about competitiveness.”

“The euro zone as a whole has a current-account surplus so you can’t argue that the zone as a whole has an issue with the level of the euro. That doesn’t exclude that some individual countries, regions or sectors have an issue. The reality of being in a currency zone is that you have to sort out these issues internally.”

On leverage ratio lifting to 4 percent:

“We believe in the necessity of higher capital requirements. We also believe that the leading requirement should be the risk-weighted ratio.”

“If the level of discretion that banks have in setting risk weights leads to too-low risk weights, or if risks lie sovereign risks are deliberately underpriced, I think we need a backstop. To decide on a level below which risk weights effectively cannot fall.”

“Current Basel standards suggest a 3 percent leverage ratio for all banks and a 7 percent risk-weighted requirement. If you lift 7 percent risk-weighted to up to 10 percent for the systemically important banks, as we do in the Netherlands, then it makes sense to also lift the leverage ratio from 3 percent to 4 percent so that the backstop moves in tandem with the binding requirement, and that’s still the risk-weighted requirement.”

“Incentives have everything to do with the relative risks and that’s where the leverage ratio is simply too basic in that it treats all risks equal whereas in the meantime we know that not all risks are equal.”

On banks’ recapitalization needs:

“If policy makers comment too much beforehand on the expected outcome of a test like this, it undermines the credibility of the outcome. We should be very disciplined in taking the test as it is and not suggesting a certain desired outcome of the test in terms of a number of capital or banks that should fail.”

“I’ve put my energy in designing a very serious and rigorous test. Now, we are putting our energy in applying the very rigorous test and we simply have to accept the outcomes as they are. If I believed that such high numbers would come out, I would have thought that many supervisors would have acted some time ago.”

“If you believe in a functioning capital market then a viable bank will be able to present a good business proposition. If there’s a thorough asset quality review being applied, all the losses are accounted for. So there is a clean balance sheet being presented to the market. Banks should then be able to find equity investors.”

“If they nonetheless can’t find it in the market, we from the central banking side have always insisted on public backstops being in place. The credibility of the test is also being determined by the credibility of the backstops. The heads of state and ministers of finance have made a very clear commitment that these backstops will be in place. National backstops, yes, but we take them by their word.”

On centralizing resolution:

“My opinion has always been that there needs to be consistency between control and liability. If supervision moves from the national to the European level then resolution and backstops should also move in parallel. If there’s an inconsistency between the two you potentially have a conflict of interest building in the system. It’s very hard to envisage that national resolution funds or possibly even national taxpayers’ money will be on the line because a European entity has failed in supervision. The two therefore need to move in tandem.”

“If you look at what has been achieved, a lot has been achieved, also in the SRM. There is a truly European approach, but it will be implemented with a slight delay. There’s the 10-year period in which resolution funds will be built up. It probably means that during those 10 years the backstops will also remain predominantly national.”

“I would have preferred a perfect alignment of supervision and resolution but I understand that from a political perspective there are these legacy issues. I understand why this gradual transition phase is there. All in all, the glass is clearly more than half full.”

On stress tests:

“Discussions are still ongoing. I expect that there will be a communication shortly.”

On Dutch economy:

“The forecasts are still modest but this time I also see some room for surprises on the upside.”

“To explain why the Dutch economy has lagged the euro-zone economy, you have to understand the housing-market issue. There has been something of a bubble, partly tax-driven. Tax incentives played a huge role there, but the situation became unsustainable. This has changed now. House prices have declined 20 percent nominally, and between 25 percent and 30 percent in real terms since 2008. But this price decline seems to have come to a halt somewhere mid-2013. Since then, the monthly readings are actually flat or on average slightly increasing, of course subject to regional differences. That makes individual consumers more comfortable again to start transacting, so the level of housing transactions is now also increasing again. The drag on consumer confidence, on consumer disposable income and on private consumption is probably now lifted.”

“Most of the fiscal consolidation has taken place through tax increases, eroding real disposable income. Real disposable income has declined by an average of 7 percent between 2009 and 2013. In 2014, real disposable income is expected, for the first time in all those years, to witness a slight increase again. That explains why I think we’ve had the worst behind us. Still we are cautious in our forecast. But there is no need to think that the Dutch economy will structurally lag the euro-zone any longer. In the quarter to quarter numbers we’re seeing that investment is picking up. It seems that world trade is also picking up, so the export sector will profit from that. If you look at the PMI readings, the Netherlands has actually led the pack already for many months. So the soft indicators are good, and the industrial-production readings have also improved. We will have to wait for mid-February to see whether the fourth-quarter GDP numbers confirm the gradual recovery of the Dutch economy.”

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