Where does the ECB go next?

It is now clear that central bank interest rates have peaked in most advanced economies; the Swiss National Bank has even started the loosening cycle with a surprise cut last week.

But this is no ordinary turn in the monetary cycle — because this has been no ordinary tightening process. Central banks, like everyone else, were taken by surprise by Russian President Vladimir Putin’s energy war and how it and other pressures drove up inflation. For the past two years, monetary policymakers have been in a situation of very high uncertainty and of learning on the job. If the coming months mark the turn in policy stance, it is also a good time for them to take stock of how they adapted their analyses in real time and what framework they will adopt for the next phase of the cycle.

The decision makers at the European Central Bank have been doing precisely that in recent speeches and comments, not least at last week’s “ECB and Its Watchers” conference (programme and links to the speeches here). Here are some thoughts about what we have learnt.

The ECB seems pretty likely to cut in the second quarter (most probably in June). President Christine Lagarde’s conference speech gave a road map to how the decision will be made. She said she and her colleagues would look particularly closely at three variables to determine if disinflation is on the right track: wage growth (which influences services prices); unit profits (which indicate how much business owners are willing to absorb costs — on which more below); and productivity (which determines how much can be shared between labour and capital without driving prices up). She also flagged important new data scheduled before June, including whether the inflation path from the ECB’s March forecast remains on track. So for those who need to guess the ECB’s near-term moves, Lagarde has told you where to look.

But for everybody else, it is much more interesting to think about the longer-term questions for the ECB: how to assess the inflationary episode of the past three years, how the central bank’s approach has evolved through it, and where it goes from here, long-term. These are the questions I have had in mind when looking at the latest communications from Frankfurt.

On the first question, ECB chief economist Philip Lane recently put out a comprehensive chronicle of the past three years, going through the shocks and surprises in detailed chronological order, and explaining how the ECB thought about its challenges in real time. Two observations, in particular, jumped out at me from that and Lane’s detailed conference slides.

The first is that the ECB’s big misses in forecasting inflation in 2021-22 (shared, as Lane shows, with most other forecasters) were almost entirely down to energy and later food prices changing more than expected. Now, commodity prices are notoriously volatile and hard to predict. It’s not at all clear that we would want central banks to do anything else than go with market forecasts, and it’s abundantly clear that we can’t fault central banks for not guessing Putin’s next move.

The second are the results from an ECB exercise of applying to eurozone inflation the method Ben Bernanke and Olivier Blanchard developed last year to decompose price dynamics in the US, which Free Lunch covered at the time. I interpreted the Bernanke-Blanchard analysis as showing that US inflation was predominantly supply-driven; the ECB exercise suggests an even more overwhelmingly supply-side story for the eurozone. (My colleague Chris Giles recently wrote an excellent deep dive into this sort of exercise for a number of major economies — I have stolen, I mean reproduced, his chart below.)

All this number-crunching strengthens my largely nihilistic view that there was little the ECB could do to either guess inflation better or to prevent it. As I have explained, there may sometimes simply be nothing central banks can do, and if so, we need to finesse our politics of inflation to fit this reality, at least so that central banks can content themselves with doing no further harm to the economy.

What, then, about the ECB’s response over the past few years? Nobody from the ECB will say so explicitly but, from the outside, it looks like the new monetary policy strategy, unveiled as recently as 2021, unravelled or at least was put in the deep freeze once inflation became embarrassingly high. My impression is that ECB policymakers lost faith in their own institution’s forecasts (and those of others, no doubt) after the many big misses — which coincided with the harshest reputational pressure on the central bankers as inflation reached levels not seen in 40 years. Such a loss of self-confidence was clearly going to become a problem for a strategy centred on being permissive with current price growth so long as inflation was forecast to be under control towards the end of a multiyear forecast period.

Instead, the dominant message from the ECB at the time of peaking inflation was what executive board member Isabel Schnabel called “robust control”. This was the notion that when the persistence of excessive inflation is highly uncertain (as one must have believed it was if forecasts were no longer informative), a central bank must err on the side of tightening.

This perspective has receded. But a less strident version can be found in the view that there is a difficult “last mile” in getting inflation down the last bit towards the 2 per cent target. It looks to me like there is less agreement within the ECB on this than it likes to let on. That disagreement could intensify, given that both sides have data to support their case. The ECB’s official forecast shows that by mid-year inflation will be at 2.2 per cent — basically, job done (see chart below). But the fact that month-on-month inflation has risen quite strongly in the past two months on a seasonally adjusted basis could well cause ructions inside the ECB on the timing of any imminent loosening.

This unsettled state of monetary thinking within the ECB can be gleaned from, for example, Lagarde’s choice to specify that “even after the first rate cut, we cannot pre-commit to a particular rate path”. In other words, the ECB reserves the right to wait and see after an initial cut, or even to do “one and done”. Observers may be forgiven for thinking that this is not much of a framework.

Hence the important question of what analytical perspective the ECB will take on the inflation process in the longer term, and which lessons it will permanently absorb from the past three years. It’s too soon to answer this, but I want to highlight one important element that already seems clear. That is the by now consistent focus on profits. Lagarde has highlighted it many times, and it’s worth reading new executive board member Piero Cipollone’s speech from earlier this week, a large part of which is devoted to how understanding the evolution of profits should make us less single-mindedly worried about wage growth being temporarily high. Cipollone points out that the inflation target could also be threatened if insufficient wage growth reduces demand growth and in time holds back productivity and potential output.

Monetary policymakers’ (re)discovery of profits is excellent news. It should be obvious that price pressures are related to profit dynamics as well as wage and input costs (and company and production taxes). Yet, until recently, the overwhelming focus of policymakers in Europe had been on labour costs. This got some central bankers in hot water at the start of the tightening cycle, when they sounded like they were blaming workers for inflation. That attitude is not just economically but also politically inept. And this goes not just for monetary policy: the handling of the eurozone debt crisis was marred by an excessive focus on labour costs (which made the solution seem like cutting wages) to the exclusion of profits (which would have pointed more to competition and financing).

This more nuanced thinking around wages and profits is welcome, then. Beyond that, it is hard to distil an updated framework from ECB communication. There are good reasons why that is so. The previous framework was found unserviceable as soon as the going got tough, and it’s inevitably difficult to come up with a new one while we’re still trying to understand what is going on today. In particular, if disinflation goes further and faster than currently predicted, the old rather stimulative approach may come back into its own. In fact, those on the hawkish side may want to loosen sooner rather than later, precisely to prevent a return to the unconventional policies of yesteryear.

There are many voices reminding the ECB that its tightening until now may still not have hit the economy fully. For example, Bank of Spain governor Pablo Hernández de Cos said in his conference speech that “a stronger than expected monetary policy impact remains a downside risk to the euro area growth outlook”.

Even Axel Weber, former head of the not-known-to-be-dovish Bundesbank, said that “most of the impact of central bank tightening is still ahead of us”. Schnabel, meanwhile, devoted her conference speech to the difficulty of knowing “R-star” — that is to say, which level of ECB interest rate is neutral in the sense of neither stimulating nor restricting economic activity.

Uncertainty all around, then. The sooner the ECB can tell us how it will now make sense of it all, the better.

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Source: Economy - ft.com