Volker Wieland The trouble with low interest rates

As the European Central Bank meets to consider its next moves, one of Germany's top economic advisors warns of serious risks in the monetary policies of the European Central Bank, the U.S. Federal Reserve and China.
Volker Wieland warns that continuing to keep interest rates near record lows entails major risks for the global economy.

Another meeting, another tough decision for Mario Draghi and the European Central Bank.

The ECB president and his governing council meet Thursday to discuss the central bank's next moves to get Europe's economy growing again. Despite the fact that Mr. Draghi widely disappointed financial markets with his last performance in December, most economists don't expect any big decisions to be taken this week.

The lack of action doesn't mean the challenges are over. Inflation in the 19-nation euro zone stood at just 0.2 percent in December, thanks largely to plunging oil prices, which is far below the ECB's own goal of keeping inflation around 2 percent. On the other hand, one measure should give Mr. Draghi hope: An ECB survey of banks this week found that companies and households are demanding more loans and getting easier access to them.

While falling prices are still a major worry for Mr. Draghi, he's widely expected to hold off with his remaining firepower, at least for now.

If it were up to Volker Wieland, the ECB would not only hold its firepower, but even dial back some of the aggressive steps it has taken in the last few months to inject money into the European economy. Instead, he warns that continuing to keep interest rates near record lows – not just at the ECB but also at the U.S. Federal Reserve – entails major risks for the global economy.

Mr. Wieland is a much sought-after expert on monetary policy in Germany. Since 2013, he has been one of the five members of Germany’s Council of Economic Experts, a group known as the "wise ones" that analyze the state of the economy for the federal government and deliver an annual advisory report.

Mr. Wieland is a professor of monetary theory and policy, and he teaches at Goethe University in Frankfurt. He is also managing director of the Institute for Monetary and Financial Policy. After earning a Ph.D. in Economics at Stanford University in California, he worked for five years as a senior economist at the board of governors of the Federal Reserve System in Washington. He returned to Germany in 2000.

For a recent interview with Handelsblatt, Mr. Wieland brought along the latest report from the panel of economic advisors. The report is more than 400 pages thick. In it, the five economists strongly challenge the European Central Bank’s purchasing of government bonds. The panel’s recommendation is similar to his own: Given the risks to financial stability, the ECB should greatly slow its massive bond-buying program or end it altogether ahead of schedule.

In the advisory council, we assume a growth of 1.6 percent for 2016. In my view, there is presently no reason to reduce that forecast. The weaker demand from China is being compensated for by the positive development in the USA and the recovery of the euro zone. Volker Wieland, Member, Germany’s Council of Economic Experts

Handelsblatt: Mr. Wieland, the governing council of the European Central Bank is meeting Thursday. The markets are hoping for a further loosening of its monetary policy. And you?

Mr. Wieland: I'm of the opinion that it was unnecessary for the ECB to have further relaxed its monetary policy [in December] since the economy in the euro zone has recovered and core inflation is positive and stable without energy prices. Moreover, the low interest policy holds too many risks. With the ECB constantly ensuring cheap financing, there is no pressure on the states to reform.

But the situation in China is currently causing great uncertainty in the financial markets. What is your assessment of this risk?

The impact on the markets in Europe and the world is greatly exaggerated. German exports to China may be declining but they make up only a small portion of our exports. More significant are the repercussions on the financial markets. If it causes overreactions there, it will affect us.

Is there a danger of a major slump in China?

That's unlikely. Although China is going through a bumpy process of adjustment, the stock market there doesn’t have that great of a significance. Moreover, wages in China are overall so much lower than in neighboring countries Taiwan and Korea that they still have a lot of catching up to do.

How do you explain the intense reaction of share prices?

Without a doubt there are risks. The Chinese state greatly intervened in the economy during the financial crisis through government expenditures and the central bank. That contributed to risks being built up in property prices and loans for companies. Added to that is that the level of information isn’t the same as here. We have data but we don’t know how dependable it is. That reinforces the uncertainty.

What effect will that have on growth in Germany?

In the advisory council, we assume growth of 1.6 percent for 2016. In my view, there is presently no reason to reduce that forecast. The weaker demand from China is being compensated for by the positive development in the United States and the recovery of the euro zone.

What effect is the influx of refugees having on growth?

There is likely to be little impact from the direct spending for the refugees. It is at about 0.1 percent for 2016. That isn’t the driver of the economy.

Then what is?

The main pillar is private spending. Naturally, the low oil prices are helping. We have high wage agreements and full employment. Added to that are the low interest rates and the devaluation of the euro.

In December, the U.S. Federal Reserve raised interest rates for the first time in almost 10 years. What effect is that having on the euro zone?

It tends to help the euro zone because it forces down the euro’s exchange rate. I think it is a positive step. But it comes much too late. If you look at the growth and price development in the United States, the Fed should have acted much earlier. Then the ECB perhaps wouldn’t have maneuvered itself into such an extreme monetary policy.

But prices in the United States are hardly climbing.

At the moment, the price of oil is concealing it. But core inflation, without energy and food prices, is at over 1 percent and unemployment is at a normal level. However, monetary policy at practically zero interest rate is still in an extreme situation. We need to have significantly higher interest rates.

Will interest rates in the United States continue to increase?

That’s what I assume. But there is great uncertainty about what direction prime lending rates will go in the long term. Will they increase to 2 or 3 or more likely 4 percent? The markets’ interest rate expectations are significantly below the Fed’s forecasts. I think the Fed’s chair, Janet Yellen, is pursuing a risky policy.

Why?There is reason to fear that the Fed won’t manage to increase interest rates in such a way that they only moderately slow down the economy. That is why there is a high probability that inflation will overshoot in the United States, meaning it will shoot up too quickly. But there is yet another danger.

What’s that?

Asset prices have been inflated due to loose monetary policy. Then, when interest rates rise, and possibly the expectations change drastically about where things are headed in the long term, stock and property prices could nosedive and there is the risk of another recession.

Wouldn’t that speak in favor of a cautious exit?

Certainly. Except that when you want to go a long way with small steps, then you have to begin early, otherwise you won’t make it. The longer you wait, the greater the risk.


Jan Mallien covers monetary policy for Handelsblatt out of Frankfurt. To contact the author: [email protected]