Well, thank you very much, Adam, for these very nice words, and thank you also very much for the invitation to speak here in front of such a distinguished audience and also at a time of potentially great consequence for the US and the European economies. We surely live in interesting times. After the COVID pandemic and after Russia's brutal and, I would add, barbaric invasion of Ukraine, history is now taking a new turn. It is clear that the new US administration has pressed the reset button in its relations with many parts of the world, including Europe. Now, where these relations will go is still unclear, although I remain hopeful that reset will not become eject. It will probably take some time before we will see the full economic effects of the seismic changes that have taken place over the last few months, or as the American rock band the Eagles sang in the 1970s, we'll find out in the long run. But as a central banker, of course, as with most policy makers, unfortunately, you cannot always wait for the long run. So what I would like to do with you today is discuss some of the implications of the latest developments for the European economy, for inflation, for monetary policy, and also for the role of the euro, based of course on what we now know in the euro area after a couple of years with very high price increases. We've finally left the inflation surge behind us. Looking at our projections, the ECB's inflation target of 2% is now clearly within reach. So, one would expect monetary policy to return to stable waters. But then, unfortunately, somebody threw a stone in the water. And basically, we're talking about two stones here. First, the imposition of significant import tariffs and the pretty extreme uncertainty surrounding it. And secondly, the prospect of higher defense spending in the euro area. And given that this situation has not yet stabilized, it is difficult to estimate precisely what the impact of both developments will be on growth and inflation. But with that disclaimer in mind, let me give you a shot. Firstly on the impact of the tariffs, economists clearly see an increase in tariffs typically as a negative supply shock because it makes traded goods more expensive. For European firms, US tariffs potentially also contribute to lower foreign demand. But that's clearly not the entire story.
The heightened uncertainty surrounding these policies undermines economic confidence, dragging further down demand. Firms will be more hesitant to invest when they cannot be confident about policies, and households may be less likely to spend if they are worried about a recession. So the recent pessimism on financial markets, in my view, presents clear evidence of that. Our own models at the Dutch Central Bank suggest that a US tariff of around 25% on imports from Europe would lower Euro area growth by about 0.3 percentage points. Tit-for-tat retaliation would further increase the drag on both the EU and the US, and the brunt of the impact on growth would be around the second year after the tariff hike. Afterwards, it would moderate over time, but it would leave a persistent decrease in output. In a world with higher trade frictions, we're simply all worse off. Now, many such estimates have been produced recently, including also by the Peterson Institute. And so I think that in this crowd it's fair to say that I'm preaching to the choir when I say that tariffs are bad for the global economy. On inflation, views differ a bit more, and the effects are also harder to simulate with our models. According to our simulations, inflation would likely rise in the short term and then it would turn lower again after about a year as the result of the slump in demand. Nonetheless, initial reactions to the tariff news indicate that actually the effects this time around may play out quite differently. Policy uncertainty is pulling forward the demand effect. And more generally, current movements in markets are going in different directions than our models predict, especially when it comes to the exchange rate. The strong euro together with falling energy prices suggest that the near-term impact might not be so inflationary after all.
For the medium term, however, there still is the risk that disruptions in global supply chains will put upward pressure on prices. The inability to capture this situation in our models as it is unfolding, combined with the high levels of uncertainty, makes this a very, very challenging environment to navigate, especially since besides the US trade shock we also have to reckon with major fiscal policy changes. The shift in US foreign policy together with a continued Russian threat has finally gotten Europe's attention when it comes to taking care of its own defense. Many European governments are prepared to borrow substantially more for this aim, and in Germany, the famous Schuldenbremse, the debt break, has been lifted. Now, the prospect of higher European defense spending as well as Germany's historic fiscal boost will have an upward impact on growth in the medium term. The upcoming boost in government spending is already reflected in business and investor confidence surveys and in market pricing. Of course, it remains to be seen how fast these ambitions can be realized and how exactly additional spending will affect growth and productivity. In any case, especially given the still tight labor markets, it seems likely that the fiscal boost will contribute positively also to inflation, an effect that will build up over time as spending is being ramped up. So, what does it all mean for the ECB's monetary policy? Well, needless to say, the ECB's Governing Council is focused on maintaining price stability in accordance with our mandate. Our interest rate decisions have been guided by three criteria: the inflation outlook, underlying inflation trends, and the strength of monetary policy transmission. So, first, the inflation outlook. The latest figures and the ECB's most recent projections dating back to March show that inflation is well on track back to target. In these projections, inflation has been revised upwards slightly in the short term, which means that the moment when we will be expected to hit the 2% has been pushed back a bit to early 2026.
However, that was all under the assumption of high energy prices, which have fallen since. So, in the near term, inflation might well fall faster due to the euro's appreciation, lower energy prices, and the negative impact of uncertainty surrounding the tariffs on growth. In the medium-term, however, the effect of tariffs is much more uncertain. Even if the demand effect persists, supply chain disruptions and retaliatory tariffs could push up prices. Similarly, all things equal, the fiscal impulse will contribute positively to inflation. So, while near-term risks are downward, for the policy-relevant medium-term, this is far less clear. Second, we carefully monitor the dynamics of underlying inflation, the sort of persistent component of inflation. Inflation in the services sector is still elevated, but it is also falling as expected, as is wage growth. So at the moment this is also looking quite good. We will, however, keep an eye on the extent to which the fiscal boost will put pressure on the already tight labor market. And third, we will consider the strength of monetary transmission to the economy. What we see here in the left chart is that the decreasing degree of monetary tightening is reflected in the loan and savings rates for households and firms, which are already much lower than last year's peak. In the right-hand chart, we also see that loan volumes are gradually increasing, a trend which picked up further in February. To assess whether this recovery will continue, we also closely watch how markets are digesting the news of the past weeks and how this is passing through to financing conditions. It was on the basis of all this assessment that the ECB last week cut its policy interest rates further by 25 basis points to a level of 2.25 for the DFR. And it effectively means that the ECB continues to gradually lift its foot off the brakes even further. Now looking forward, what we will continue to do is simply take a data-dependent and a meeting-by-meeting approach to determine the right monetary policy response. And for me personally, our last meeting was the perfect illustration of the importance of this.
Before the US tariff announcements, I was increasingly confident that inflation was developing in line with our intentions and that maybe we could have argued for a hold in rates. But recent events have however increased near-term downside risks to inflation. And so I was fully on board with the decision to cut rates. It ensures us against the near-term downside risks to both growth and inflation. But as I just argued, over the policy-relevant medium-term, uncertainty around the outlook is much more symmetric. For me, this suggests that a policy rate that is neither accommodative nor restrictive broadly remains the right place to be. In any case, we will keep our medium-term focus and we will aim to set policy in a manner that will result in inflation around our 2% target sustainably and with sufficient confidence, not just in the baseline but also in a range of scenarios. So, I talked about the economy, inflation, and the ECB's monetary policy. But what does all this economic mayhem, if I may use this term, mean for the euro? And especially what does it mean for the international role of the euro? Now, one thing that you should know is that discussions about the international role of the euro are actually older than the common currency itself. Back in 1997, so that was two years before the introduction, I was as a young economist just having joined the monetary policy department of the central bank. I was at an IMF seminar about the implications of the euro for the international monetary system, and what I recall from that seminar was that there was wild speculation about whether the euro would become a major reserve currency. Few, however, believed that the euro would be able to dethrone the dollar as the world's leading currency. And of course, that also didn't happen. Upon the introduction of the euro, its international dimension initially developed well. The euro's external use rose above the combined share of its predecessor currencies, notably the Deutschmark.
But then we got the global financial crisis, soon followed by the Euro area debt crisis, which laid bare serious design flaws in the economic and monetary union, and that did not exactly help to boost the euro's international appeal. However, recently commentary has been building that the euro might actually be heading for a comeback. At a minimum, the momentous shift in US economic policies provides a natural moment to revisit the issue. The international position of a currency is to some degree based on a self-reinforcing mechanism. People around the world use dollars to make transactions and set prices, and they also therefore hold a lot of dollars, and because of that, other people are inclined to do the same. Kindleberger once compared the role of the dollar as an international currency to the role of the English language as an international language. And I think that's quite a good and apt comparison. Because of the strong pull of this effect, it usually takes a crisis to dethrone a world currency. The pound, the British pound, was replaced as dominant currency in the period between the world wars. While in most recent periods, Brexit contributed to a further dollarization of non-EU trade in the UK, and the role of the euro in international financial markets substantially dropped during the Euro area crisis years. With the geopolitical tensions, the trade war, and the unusually high uncertainty about the future course of US economic policy, it is only natural for reserve managers to rethink the diversification of their foreign currency portfolio. And a question that then comes to mind is to which extent the dollar can still be regarded as a safe haven. In the same vein, the current juncture offers an opportunity, an opportunity for the euro. For all its flaws, the European Union remains a pillar of the rules-based world order, which in an increasingly uncertain world may be the ultimate safe but increasingly scarce asset.
So this gives rise to the question: should European policy makers actively pursue a larger international role for the euro? Now, the ECB has traditionally taken a rather agnostic view to this, and I've always shared that view. Promoting the international use of the euro has never been part of our mandate as a central bank, a mandate which is indeed solely focused on maintaining internal price stability. The external use of the euro is at the end of the day a reflection of the strength of the European economy and its financial markets, and it has both positive and negative implications for the central bank's control over inflation. Nevertheless, I think that my agnostic attitude recently seems to have shifted somewhat, shifted towards a state that perhaps could best be described as a cautious believer. And the main reasons for this gradual shift is actually the need for more European strategic autonomy in an increasingly hostile world. The benefits of this are obvious when it comes to payments and international financial markets. European payment systems and financial markets infrastructure are highly dependent on foreign services providers. And this makes the operation of our vital economic functions vulnerable to sudden shifts in policies by foreign countries to an extent that many Europeans would no longer find acceptable. It is also from this perspective that the digital euro could prove a valuable innovation. But the benefits extend well beyond such considerations. Invoicing more important goods in euros helps to shield Europeans from exchange rate shocks, and a greater demand for euro-denominated assets can draw in foreign investors, which reduces financing costs for governments and firms. And this is the so-called exorbitant privilege that over the years has become so attached to the dollar as the world's number one currency.
This privilege may be even more pronounced in times of stress due to safe haven flows taking place in such times, and indeed the smooth absorption of government bonds that have become available on the back of quantitative tightening by the ECB, with a substantial share being snapped up by foreign investors, is perhaps an indication of the attractiveness of safe euro-denominated assets of foreign investors. I think we can safely say that quantitative tightening has been facilitated by the attractiveness of the euro. At the same time, a larger international role of the euro also comes with responsibilities. Foreign entities may look at the ECB in times of market distress in a way that the Federal Reserve has been central in the international monetary system. Fortunately, the ECB has also evolved over the years and it has a wide range of tools at its disposal to safeguard price stability and to stabilize financial markets if need be. So in my view, a more widespread use of the euro would be a good thing also for the Europeans. The next step then is of course what steps should European policy makers take to strengthen the international role of the euro. Well, as I already said, the external strength is a reflection of our internal strength. The external attractiveness of a currency can therefore be supported by policies that improve the strength and the efficiency of its economy and its financial markets, backed by robust institutions. For the ECB, that means continuing to fulfill our mandate of maintaining price stability, and this helps to underpin a healthy economic development. It supports investor confidence in euro-denominated assets retaining their value.
During the IMF conference that I mentioned, almost 30 years ago, this was indeed seen as a key condition, and I'm pleased to see that overall we've done a good job of meeting this condition. As for governments, in addition to remaining committed to being an open, dynamic economy and an anchor for the rules-based world, important steps need to be taken to integrate the internal market and in particular to integrate and to deepen financial markets. And here we still have quite a lot of work to do in Europe. Strengthening the inter-European internal market would first and foremost be good for the European economy and for European companies and households. The IMF has recently estimated that by reducing barriers in our internal market to levels comparable to those in the United States, the EU could increase its productivity by no less than seven percentage points. And as a welcome byproduct, this would probably also increase the attractiveness of the euro as a world currency. Secondly, we currently do not have a single capital market like you have here in the US. If you as a US investor wish to invest in firms across the EU, you potentially have to deal with up to 27 different sets of rules and regulations. For example, when it comes to corporate law or insolvency frameworks, and that clearly diminishes the attractiveness of our capital markets. It also means that we have to forgo billions of euros in risk-bearing capital that could help boost new firms and new technologies. If we would succeed in harmonizing these rules and in removing the remaining barriers to cross-border capital movements, that would lower the cost for foreign investors to enter the European capital market. It would make it easier for European firms to issue debt, which in turn could lead to a further deepening of capital markets. Another example of a self-reinforcing mechanism. And this would then clearly boost private investment and make the European economy more resilient. So the diagnosis is clear as well as the treatment. But until now, harmonizing regulation has proven to be a formidable obstacle. Still, if we ever want to equal the dynamism and the size of US capital markets, we really need to make progress in this area.
Another specific policy action that may contribute to a larger role for the euro is the further issuance of common safe assets, also called euro bonds. They were once quite controversial, but the experience with EU bonds that were issued during the pandemic was positive. The demand for these bonds among non-European investors has been a welcome reflection of investors' faith in Europe's financial solidity. The European Commission has proposed the issuance of additional common debt to finance the higher defense spending, and further issuance of this euro-denominated safe asset would be a strong signal of further unity and integration in these divisive times. It would also signal that the issuance of common debt during the pandemic was not a one-off and that more structural issuance would likely further increase the attractiveness for investors. It could be particularly helpful at a time when investors may be considering the distribution of their international asset holdings. Mechanically, adding supply to the market helps to make the Euro bond market more liquid, potentially further drawing in investors, and this could also have helpful spillovers to other parts of Europe's debt markets. Of course, the strength of the euro is highly dependent on sustainable public finances. The average Euro area government debt-to-GDP ratio is currently 88%, which is notably lower than the US federal debt ratio. But there is a but: this debt ratio is very high in a number of countries. Now, given the urgency that we all feel around higher European defense spending, a temporary increase in public debt may well be unavoidable. At the same time, what I believe we should avoid is this continuous ratcheting up of debt levels after each crisis. Financing common challenges with EU debt is not a way to circumvent the need for sustainable public finances. The servicing costs of EU debt are ultimately borne by the same taxpayers as those of national and local debt, even if common issuance can lower the average cost. In the medium-term, higher EU debt should therefore go hand in hand with lower national debt levels, and an exception to the EU fiscal rules for national spending should be limited in time and scope. In other words, for defense expenditure only.
I'm wrapping up. So, the momentous events of the past months will have their bearing on the economy and inflation for sure. For the ECB's monetary policy, it means that we will continue to take a data-dependent and a step-by-step approach to determine the right monetary policy response. Whether current events will have a positive impact on the international use of the euro, that's hard to say, but I would not be surprised if it did to some extent. And this can also prove valuable for the European economy. At the same time, boosting the international role of the euro cannot be a standalone policy target. As I've tried to make clear, external strength is a reflection of internal strength. Our priority in Europe should therefore be to further strengthen the internal European market, especially in times of high uncertainty. A robust EU internal market serves as a first line of defense against external shocks. So that should be the focus of European policy makers. Ultimately, a stronger euro area will imply a more attractive euro, which in turn could give a welcome push towards reaching our strategic economic goals. Now, whether you are an agnostic, a cautious believer, or whether you are preaching the gospel in the streets, that is simply how it works. And all that aside, first best would of course be that we maintain a degree of international economic cooperation and stability. The United States and Europe, we have a longstanding and we have deep historical and economic ties, and we have both long been solid pillars of a world economy that is based on rules. It is my conviction that this system has worked very well for both of us and that all of us can continue to benefit from it. After all, to cite the Eagles once again, the modern world economy is a little bit like Hotel California. You can check out anytime you like, but you can never leave. And with that, I thank you for your attention.
