A "significant" increase in interest rates is necessary in September

It's Too Early to Publicly Discuss Quantitative Tightening

The European Central Bank must act decisively to contain record inflation and maintain expectations of future price increases, as a weak euro exacerbates the rise in energy prices, said Board of Governors Member Olli Rehn.

It is important that policymakers continue to "consistently and orderly" normalize monetary policy, Ren, who heads Finland's central bank, told Bloomberg Television at the Federal Reserve's annual meeting in Jackson Hole. His comments followed remarks by Executive Board member Isabelle Schnabel and Frenchman François Villeroy de Galau, who stressed the need for a strong response – at the upcoming ECB meeting and beyond.

"The reality is that we have excessively high inflation around the world, including in Europe – that's why the time for action has come," Ren said. "The next step will be a significant step in September, depending on the incoming data and the inflation forecast."

As consumer prices in the 19-nation euro zone rise at an annualized rate of nearly 10% — an update due on Wednesday — some policymakers have begun to debate the benefits of following the Federal Reserve's scenario and raising borrowing costs by three-quarters of a point. Others are more cautious, mindful of the economic hurdles that are likely to trigger a recession.

Money market investors now see a nearly 50% chance that the ECB's September rate hike will exceed half a point.

"Monetary policy currently faces a double dilemma: on the one hand, keeping inflation expectations anchored, and on the other hand, avoiding that we will push the economy into recession," Ren said. "We have a serious energy crisis in Europe" and "it is likely that the eurozone economy is slowing down. It slows down as we speak."

The region must be prepared for a "protracted confrontation" with Russia, so reducing gas flows and raising fossil fuel prices would be a "long-standing phenomenon," Ren said. "This will mean a serious decline in the purchasing power of our citizens."

It also suggests that there is reason to worry that inflation expectations are taking root, he added. 

The recent downturn in the euro exacerbates the problem. The single currency has depreciated more than 12% against the dollar since the start of the year and is currently trading below parity. 

"Of course, we are monitoring the exchange rate," Ren said, echoing the ECB's standard line that this is not a target, but contributes to inflation and is therefore taken seriously. 

"This indirect channel is important – we follow it and see it as one of the indicators," he said. "This is already a significant consideration" in determining monetary policy.

As interest rates continue to rise, a debate is about to begin about when the ECB should consider cutting its bonds after years of asset purchases – a process commonly referred to as quantitative tightening. The Fed and the Bank of England have begun a process that allows long-term bond yields to rise.

"It's premature to start talking publicly about QT in a European context," Ren said. "We can think about it with each other, but later it will be time to discuss decisions on how to continue normalizing monetary policy on asset purchases."

A somewhat more pressing debate for the ECB is how to reward trillions of euros of excess reserves – now that interest rates are no longer negative. Villeroy told the Jackson Hole audience that paying deposit rates would provide banks with "significant risk-free returns" that could jeopardize policy transfers, having similar losses for the ECB and the region's national central banks.

"That's something I think we need to discuss," Ren said. "We have some preparatory discussions in this regard, but we will take care of it at upcoming meetings – in the plural."