ECB’s Knot Urges Investors to Take Inflation Risks Seriously
Investors must be careful not to underestimate inflation risks that could prompt the European Central Bank to tighten monetary policy, according to Governing Council member Klaas Knot.
Risky behavior in financial markets has increased sharply since the start of the pandemic, making them vulnerable to a turnaround in sentiment, Knot told reporters in Amsterdam, where he presented the Dutch central bank’s Financial Stability Report.
“This risky behavior is only sustainable at low inflation and interest rates,” Knot said. While the current spike in consumer prices can still be seen as largely temporary, “from the perspective of healthy risk management, it is also important to take other scenarios into consideration.”
Euro-area inflation is running at the fastest pace since 2008, propelled by energy and a number of statistical effects related to the pandemic that should fade next year. Yet persistent supply bottlenecks have fueled concerns that price pressures may remain elevated for some time.
“There is more in the inflation process we don’t understand than we do understand,” Knot said, adding that price pressures may be turn out to be stronger than currently projected. Consumer prices in the Netherlands rose an annual 3% last month.
The Dutch economy’s recovery is stronger than expected, and even though the threat of a resurgence in the pandemic hasn’t gone away, Knot said he remains “reasonably optimistic” about the outlook.
“I am less positive about the build-up of financial vulnerabilities and risks,” he said. “Precisely now that the economy is improving, we tend to be less aware of the vulnerabilities building up. And that is something I would like to guard against.”
The ECB is preparing to unwind emergency monetary stimulus as economies in the 19-nation euro area put the coronavirus crisis behind. But with medium-term inflation in the region still falling short of the 2% goal, an older bond-buying program and record-low interest rates will remain in place.
“A too abrupt tightening of financial conditions can lead to risks to financial stability and indirectly have a negative impact on the objective of price stability,” according to the Dutch central bank. On the other hand, keeping financial conditions accommodative risks negative side effects as a result of investors’ search for yield.
Knot also highlighted an “exuberant rise” in house prices in the Netherlands as a risk to financial stability, and argued that banks don’t take sufficient account of the systemic risk inherent in the housing market.
Climate change is part of this risk.
The central bank is concerned that extreme weather events and stricter sustainability requirements both have the potential to depress home and office values. Real estate investments and loans account for more than 25% of assets of banks, insurers and pension funds.
In a new climate stress test, the institution will investigate how a flood in the Netherlands can affect financial institutions.
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