ECB must swiftly normalise rates; neutral may not be enough, Knot says

(Reuters) -The European Central Bank must swiftly normalise interest rates as inflation could still go higher and lifting rates to the neutral level, which neither stimulates nor slows growth, may not be enough, Dutch central bank chief Klaas Knot said on Tuesday.

The ECB raised its deposit rate by 50 basis points to zero in July and a similar move was expected for September until recently, but a host of policymakers, including Knot, made the case for discussing a larger, 75 basis point increase as well.

“A swift normalization of interest rates is an essential first phase, and some front-loading should not be excluded,” Knot told a Danske Bank event. “The broadening and deepening of our inflation problem generates the need to act forcefully.”

When asked about his preference for the move, Knot hinted that he was leaning towards 75 basis points but still wanted to review data and discuss with colleagues.

In the first step, the bank should get rates back to the neutral level – somewhere between 1% and 2% – this year but Knot said he was “not convinced” that this will be enough and restrictive policy may be needed.

At 8.9%, inflation is already more than four times the ECB’s 2% target and could exceed 10% in the coming months, raising the risk that even longer term expectations move higher as businesses and households start to doubt the ECB’s willingness or ability to control prices.

Knot himself argued that there were upside risks to inflation, including from higher food and energy prices, a weaker euro, copious budget spending and rising expectations.

A recession, increasingly considered the baseline given the loss of gas supplies, would weigh on price pressures but Knot argued that this alone would not be enough.

One issue is that given the scarcity of labour, firms are likely to “hoard” labour in the initial phase of a downturn as this would be less costly than struggling to find workers later.

“Even if this slowdown were to materialize, this in itself is unlikely to bring inflation back to our objective over the medium term,” he said.

While it was uncertain where rate hikes should end, Knot argued that the ECB should just keep raising rates until the inflation outlook becomes consistent again with the ECB’s symmetric target.

As part of policy normalisation, the bank should also consider reducing its balance sheet after trillions of euros worth of bond purchases over the past decade.

A reduction in the bank’s balance sheet could come from the less than full reinvestment of funds maturing in the recently discontinued Asset Purchase Programme but this would be “very gradual”.

Talks over a balance sheet reduction could start in October or December, Knot said.

(Reporting by Balazs Koranyi, Editing by William Maclean)