By Willem H. Buiter and Ebrahim Rahbari
The European Central Bank (ECB) too often finds itself “behind the curve” of events, and we believe the blame lies with its decision-making process, rather than its institutional setup or personnel. As ECB President Christine Lagarde revealed at the December 14, 2023, press conference, “We did not discuss rate cuts at all… between hike and cut, there’s a whole plateau, a whole beach of hold.”
This statement was not just peculiar, but unhelpful. At the time Lagarde uttered it, six-month annualised eurozone core inflation (excluding food and energy prices) was at 2.5per cent, based on ECB data, having fallen for several months, to the surprise of everyone. While virtually all ECB Governing Council members now argue that monetary policy is restrictive, the totality of inflation and activity data, hard and soft, coincident and leading, ought to have invited a discussion about whether it is too restrictive.
Lagarde’s comment was nonetheless instructive, because it shows that the ECB is anchoring the timing of a potential rate cut to the timing of the last hike — that is, to the past. The implication is that the ECB’s decision-making process is not only too slow (outside of crises) but also excessively backward-looking.
Many recent examples support this conclusion. One was the late start to the recent tightening cycle. The ECB’s net asset purchases ended only in June 2022, and it began its hiking cycle only in July 2022. Another example was the ECB’s surprising decision to raise its policy rates in September 2023, when inflation had already been falling fast for several months. And yet another was its announcement, on December 14, 2023, that it would reduce the reinvestment of its Pandemic Emergency Purchase Programme (PEPP) portfolio during the second half of 2024, before discontinuing reinvestments at the end of the year.
There are three reasons for the ECB’s inertia: an excessive focus on reaching a broad consensus within the Governing Council; the disproportionate weight given to lagging data; and the “built-in” persistence of policy.
Lagarde’s consensus-focused approach is partly making up for her predecessor Mario Draghi’s tenure, which left the ECB unusually divided and she deserves credit for repairing those divisions rather than papering them over. But monetary-policy views across the ECB’s Governing Council often vary widely, owing to economic divergences and different attitudes towards inflation across eurozone member states. Under such circumstances, consensus-focused decision-making will consistently come at the expense of timeliness and effectiveness.
The ECB also seems to have downgraded the importance of forecasts in its decisions. Again, this adjustment is understandable given the large forecasting errors of recent years. But “naive” forecasts based on coincident indicators or past trends are unlikely to fare any better; it is a classic case of fighting the last war. Consider the ECB’s obsession with declining core inflation and wage growth. Unless there are clear signs of a wage-price spiral (there are currently none), wages, especially negotiated wages, are among the most lagging data in the inflation process.
Finally, the ECB’s policy measures tend to be very persistent. Its interest-rate decisions and asset purchases regularly feature extensive time-dependent forward guidance, sometimes extending years ahead. Such policy persistence was sometimes essential in the past, as with the original asset-purchase programme launched in 2015, or the initial series of very long-term refinancing operations. But when conditions change quickly, policy persistence sets the ECB up for a trade-off between time-dependent forward guidance and appropriate state-dependent policymaking.
Taken together, these three factors have put the ECB structurally behind the curve. Fortunately, there are three tweaks it can make to arrive at timelier policy decisions. First and foremost, ECB decisions should be anchored in forward-looking information. Of course, the future is uncertain, so this approach is necessarily probabilistic.
Given the rigidity of the ECB’s formal macroeconomic projection process, it would benefit from the inclusion of alternative forecasts, scenarios, and qualitative discussions of future trends.
The ECB already produces a lot of high-quality, relevant analysis that fits the bill. ECB Chief Economist Philip Lane, among others, was early in presenting work, at the ECB Watchers conference in March 2023, that suggested eurozone inflation could fall quickly. The ECB also now analyses inflation trends in impressive, and appropriately disaggregated, detail.
Second, Lagarde should re-prioritise timeliness relative to the breadth of the consensus achieved or when policy was last changed. Here, too, there are promising signs that a change could be made relatively easily. ECB Executive Board member Isabel Schnabel recently softened her own position on additional rate hikes, quoting the famous quip from John Maynard Keynes: “When the facts change, I change my mind. What do you do, sir?”
Third, time-dependent forward guidance should be limited to cases where its merits are evident and essential. In uncertain times, such cases will be rare. There is nothing stopping the ECB from making this change. It sometimes acts very quickly and decisively indeed, such as when rolling out the PEPP in March 2020, when overriding its extreme forward guidance for asset purchases in March 2022, and when announcing the Transmission Protection Instrument in July 2022. In those situations, purpose trumped consensus and pre-existing guidance. But an extreme situation is an unnecessarily high bar for timely decisions.
The economic outlook remains fluid, including for inflation globally and in the eurozone. More surprises surely await. Uncertain times call for leadership and agility — the willingness and ability to respond flexibly and appropriately to unforeseen changes in circumstances, even when there is no immediate crisis at hand.
Willem H. Buiter, a former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England, is an independent economic adviser. Ebrahim Rahbari, an independent strategist and economist, is a former chief currency strategist, global head of foreign-exchange analysis, and head of global macroeconomics at Citigroup. Copyright: Project Syndicate, 2024.
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