The interview with Joachim Nagel was conducted by Kolja Rudzio and Roman Pletter.
Translation: Deutsche Bundesbank

Mr Nagel, what do you think is of greater concern for the German economy: the collapse of the traffic light coalition or Donald Trump’s election as US President?

We were confronted with two major events on one and the same day. Both of them give rise to uncertainty and challenges for us here in Germany. Of course, I cannot predict the result of new elections in Germany. But I believe that certain decisions in the United States could indeed have grave consequences.

Let’s start in Germany. Did you think the traffic light coalition government made Germany an advantageous location up until its collapse on 6 November?

I don’t want to get involved in party-political stocktaking and apportioning blame. What is important for the current and future Federal Government is that our country is facing a huge need for action. We need to get things moving as quickly as possible.

You have been saying that in every interview for the past one and a half years.

Yes, and it’s still the case. The growth initiative that is yet to be adopted by the incumbent government is taking things in the right direction in many respects, including creating reliable conditions for the future energy supply and cutting down on red tape. Businesses, households and financial markets want reliability, especially when it comes to decisions about things like investment, where they’re making a longer-term commitment. A clear message is important. Even in personal conversations, it’s clear that politicians have to do their work, they have to build trust and a framework people can rely on. It’s no different for a central bank: if I were to doubt my ability to achieve price stability, I would run the risk of losing my credibility. Then I would risk everything only getting worse.

Is it good news for this reliable framework that the fractious three-party coalition has come to an end and that the Chancellor is now calling a vote of confidence and seeking to hold new elections?

It’s not my job to comment on that. What we need is politicians who will tackle the challenges swiftly and successfully – and set the right course to do so.

What’s your assessment of the state of the German economy?

At the moment, we keep hearing that we’re the sick man of Europe. I don’t find that fitting, and lamenting the fact won’t get us any further. But it is clear that we need to act given the challenges we face. Even the labour market is now showing increasing signs of a slowdown.

One year ago, you were still saying that you wouldn’t worry about the labour market!

The level of employment is still exceptionally high. But the outlook has deteriorated in the meantime. The jobs that we are losing in industry might not be as easily replaced as before by new jobs in the services sector.

What are the main reasons for the economic weakness?

At first, it was supply bottlenecks and the energy crisis. On top of that, we have lost competitiveness, and the recent decline in productivity isn’t the only evidence of that.

Why is that?

I have already mentioned bureaucracy. Corporate tax rates are also higher in Germany than in most other EU countries and the United States. The same is true of energy costs. However, enterprises also need to ready themselves for change at an early stage. Demographic change, for example. These days, there are jobs ads plastered on almost every trade firm’s delivery van. And those are the small and medium-sized enterprises, the backbone of the German economy.

What reform requirements do you take from this?

There are numerous ways to increase the labour supply in Germany. Going to work should be an easier decision for parents, knowing that their children will be well looked after while they’re gone. Skilled immigrant workers are already indispensable to us in many areas, and there we can tap even greater potential in the future.

Disputes in the coalition centred on the budget and the amount of social spending. Just over one-quarter of the federal budget goes towards grants to the pension insurance scheme. You yourself already mentioned demographics. Wouldn’t it make sense if the SPD had conceded to the FDP by raising the retirement age, say?

Our population is ageing, and given the way our pension system is set up, I see big question marks in the longer term. I think it’s right that those who want to work longer can do so flexibly. After all, we’re in better shape today than people of the same age were 40 or 50 years ago. In many cases, work also means participating in society.

That’s also an argument for a higher retirement age ...

Yes, it is. It would make sense for the retirement age to rise gradually in line with life expectancy from 2031 onwards. This has long been the Bundesbank’s position, and the Bank has, in fact, published calculations to back it up. If you don’t want to adjust this lever, we will pay the price elsewhere – social security contributions, the pension level or central government funding, something will have to give.

What economic consequences will Donald Trump’s election have for Germany?

Some of the measures he has announced may have serious consequences. Trump has frequently said that he will introduce higher trade tariffs. This would harm Germany considerably, as we would sell fewer products in the United States. And, we are undeniably an exporting economy. But it’s not just about tariffs – there is also the question of US government finances. Judging by what Trump has announced, government debt could rise considerably over the next ten years, with some observers suggesting a figure of up to US$8 trillion.

To what extent does that affect Europe?

It hits Europe through different channels. Tariffs and heavily debt-financed policy measures would initially fuel inflation in the United States. The US central bank would then have to refrain from making anticipated interest rate cuts, or even raise interest rates again, in order to alleviate this inflationary pressure. This would probably cause the US dollar to appreciate, which could, in turn, make imports from the United States more expensive in Europe and Germany; this might also affect oil, for instance, which is traded in US dollars. As you can see, tariffs create losers on both sides of the Atlantic.

Can you quantify welfare losses?

If the tariff plans are implemented, it could easily cost us one percent of economic output in Germany. This is very painful if you bear in mind that our economy is not growing at all this year and will probably grow less than one percent in the coming year even without US tariff plans. If the new tariffs are in fact introduced, we could actually slip into negative territory.

Did high inflation influence the US elections?

I am no expert on elections, but price developments were undeniably among the most important topics, alongside immigration and the abortion debate. We central banks scrutinise interest rate changes particularly closely, in other words the rise in prices from one year to the next. This measure is currently already close to 2% again. A lot of people look at price tags and compare them with the prices they remember from before the pandemic. And they see a huge difference.

That is understandable, isn’t it?

Yes, definitely. I notice it myself when shopping at the supermarket. And I also felt this way in the United States when I attended the annual meeting of the International Monetary Fund in Washington: a cup of coffee there can quickly set you back US$8 or more these days. This shows that there has been a massive price surge in everyday life.

The outgoing US President Joe Biden introduced the Inflation Reduction Act (IRA) two years ago. However, there is a theory that this subsidy programme has, in fact, amplified inflation because government demand has driven up prices. Is that true?

There is indeed some empirical evidence for this theory. While inflation in Europe has been driven more by high energy prices, in other words, there has been a supply shock, the main driving force in the United States has been excessive demand. The IRA programme and other government programmes have further fuelled this demand.

The IRA was largely financed with debt, which is already relatively high in the United States. How problematic is this?

In order to finance high government debt, there must always be someone willing to buy debt securities. If debt rises sharply, creditors will typically demand a yield premium, i.e. higher interest rates. China, incidentally, holds a significant share of the government debt that the United States has made over the past two decades. If the world becomes more divided, it could prove more difficult and more expensive for the United States to find takers for its debt securities.

The US government is unable to manage without new borrowing, even though the economy is running at full speed and thus tax revenues are also relatively high. How does that add up?

The desire to spend more money than you have is understandable. However, high and growing levels of debt usually don’t end well in the long run. And in an economic crisis at the latest, they would become challenging to deal with from a fiscal policy perspective as social spending then increases at the same time as tax revenue falls. But if governments already do this in boom periods, there is no financial leeway when times get tough.

Do you see this as a threat to the stability of financial markets?

Excessive government debt is, generally speaking, a risk to financial stability. Over the past four or five years, financial markets have responded relatively calmly to various crises, new debt issues have found buyers, and risk premia have been at relatively favourable levels. But financial markets are like shy deer – if they are startled, they can also become quite volatile. I do not see a crisis at present, but in the current situation we must expect higher price fluctuations. US debt has the potential to become uncomfortable.

What risks do you see for the equity markets?

Uncertainty is a major risk in the medium term. What economic and fiscal stance will the United States adopt? Will the tariffs materialise? Will geopolitical fragmentation intensify? We could be on the verge of a global economic turning point.

How should Europe deal with this?

We have to get our act together. In this situation, we need more Europe, not less. EU countries should dismantle barriers in their common market, starting with the capital markets union, which I hope will finally come to fruition. With uniform rules, professional investors as well as savers would have better opportunities to put their money to work. Another problem is that many things move too slowly in Europe. This, too, has to do with rules and bureaucracy. Enterprises have to dedicate a very large amount of time and personnel to meet regulatory requirements. For many, this is simply off-putting.

Your day-to-day job is to combat inflation. Has inflation been defeated?

Inflation is a greedy beast. We now have this beast under control again. Euro area inflation currently stands at around 2%, which is the level we aim for in the Eurosystem. But the work of a central banker is never complete. The art is keeping inflation permanently at 2%.

Might it be the case that you are actually overdoing the control side of things? That you are keeping interest rates high for too long and thus damaging the economy unnecessarily through expensive loans?

We are not overdoing it. There is still significant price pressure, mainly stemming from the services sector on account of wage factors. This inflationary pressure is being masked by the decline in energy prices. Core inflation, i.e. the inflation rate excluding highly volatile energy and food prices, remains fairly high, standing at just below 3% in the euro area, but still above 3% in Germany.

Two studies by renowned research institutes have recently concluded that the ECB could have prevented some of the latest sharp price increases if it had raised interest rates earlier. Are you perhaps again a little too late in reversing interest rates, like at the beginning of the last wave of inflation?

Timing has always been a major topic in monetary policy. That is why, also in these uncertain times, we take decisions from one meeting to the next based on the incoming data and forecasts. It is nevertheless difficult to hit the exact point at which interest rates should ideally be raised or lowered. But I firmly believe that we’re on the right track.

During the most recent wave of inflation, there was also talk of “greedflation”, whereby some firms were said to have raised prices disproportionately and taken advantage of the general inflation sentiment. Has this exacerbated the situation?

In periods of inflation, firms with a strong market position and few competitors often take the opportunity to raise their own prices. The special situation in the coronavirus crisis will have played into this. From around mid-2022, when inflation figures were very high, such behaviour on the part of individual actors temporarily contributed to inflation and intensified peaks.

In which sectors in particular?

Without mentioning individual actors and sectors, I can say that the phenomenon only occurred temporarily and that price formation has returned to normal. This, too, is good news in these times.

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