The Real Test for the ECB’s New Strategy
As the old saying goes, the proof of the pudding is in the eating. A commentary by Lorenzo Bini Smaghi.
The European Central Bank just published the latest review of its monetary policy strategy. As expected, there are no radical changes, but rather the confirmation of choices that have, for the most part, already been made.
Nevertheless, at least three points warrant further reflection.
The first is that the central bank does not intend to provide markets with overly precise guidance regarding its next moves, whether up or down, on interest rates.
This may disappoint those market participants and commentators who believe that the central bank should announce its decisions well in advance and avoid surprising markets.
However, if the central bank were to comply with this request, it would risk, in a climate of heightened uncertainty, becoming trapped in a cycle of continuous communication, which would inevitably dilute the impact of its message. This, in turn, would undermine its credibility.
Financial markets must make the effort to form their own forecasts, knowing that, in the end, the central bank will act first and foremost to counter inflation.
The second point, partly related to the first, concerns the ECB’s intention to enhance its analysis with a series of alternative scenarios, to simulate more extreme developments in the macroeconomic outlook.
While the use of scenarios for internal purposes may be helpful—particularly to understand the effects of forecast errors—it remains unclear how this will improve the decision-making process, and above all, the ECB’s external communication.
If econometric models have proven fragile in the past—especially for forecasting—they risk being even less reliable when simulating extreme shocks, which have little historical precedent.
It is therefore far from obvious that publishing such scenarios will provide meaningful information for understanding monetary policy; on the contrary, it may raise more fog around the ECB’s communication.
The third point concerns a key word used in the document—”forcefulness”—referring to the strength with which the central bank intends to respond to significant and persistent deviations of inflation from the 2% target.
It remains unclear what, in practical terms, this commitment will actually entail.
The document refers to measures adopted by the ECB over the past decade, both in periods when inflation was excessively low and deflationary pressures prevailed (2014–18), and when inflation surged sharply (2021–22).
Yet with the benefit of hindsight, those measures, and the manner in which they were implemented in both circumstances, can hardly be described as forceful.
In the middle of the last decade, for example, faced with very low inflation and deflation risks, the ECB dithered for an extended period with measures—such as negative interest rates and forward guidance—which didn’t prove that effective, before finally, in early 2015, embarking, with genuine force and determination, on the purchase of government bonds (quantitative easing) to increase the monetary base, as the US Federal Reserve had done since 2008.
The hope, should new deflationary risks arise, is that the ECB will turn rapidly to the most effective tools, rather than lowering rates again into negative territory.
As for the more recent inflationary experience of 2022, monetary tightening was delayed by the ECB’s prior commitment to ending asset purchases before raising rates.
Interest rates were only increased at the end of July 2022, after eight years of negative rates, when inflation had already surged past 8%. The prolonged period of interest rates below actual and expected inflation, along with continued government bond purchases, contributed to the inflationary pressures of 2022.
Here again, one would hope that in the future the central bank will act more swiftly and decisively to counter inflation, rather than binding itself with commitments that risk becoming counterproductive.
Ultimately, beyond the strategies and new or renewed commitments, monetary policy is subject to the same test as the English pudding: the proof will be in the eating.
A first version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
