ECB Strategy: Back to the Future

Four critiques and a question

Summary: The ECB’s updated strategy re-establishes symmetry of the reaction function – adding lessons learned from the recent, high-inflation episode, to the lessons from the low-inflation 2010s. I take a closer look at what’s been decided – I have four critiques and a question.

1. Thou shalt fear zero: low inflation and high inflation aren’t equal problems

2. Higher bar for QE, but what’s the alternative?

3. Higher or for longer? rates won’t be a la carte every time

4. reaction function: everything, everywhere, all at once

Q: Can you really be more forceful if inflation is more volatile?

source: Charlotte Venema on Unsplash

To great fanfare, the ECB revealed an update of its “strategy” on June 30.

(Think of a central bank’s “strategy” as a broad set of principles which guides its actions.)

Readers who want to hear it “from the horse’s mouth” may want to read Christine Lagarde’s Sintra speech, which provides a nice summary along with some color.

What I will do instead is zoom in on some issues which I think deserve critical attention. (I’m afraid this will be a nerdy post.)

But first, the strategy review’s three key conclusions.

The backdrop: we live in a more uncertain world. Higher uncertainty and more supply shocks may lead to more frequent price adjustments by firms and hence to more volatile inflation.

This higher uncertainty, and the associated distribution of risks, need to be taken into account in both analysis and communication.

Action plan: the ECB will be using and communicating scenarios more frequently and systematically going forward.

The more uncertain world may result in non-linear behaviour of inflation: inflation becomes even higher when it’s already high, and even lower, when it’s already low.

Action plan: the ECB needs to be ready to react with equal strength to both upside and downside deviations from target, to prevent a de-anchoring of inflation expectations (“two-sided reaction function”).

If the latter point seems obvious, it’s worth recalling that in the previous strategy review – informed by the experience of low inflation pressures in the post-Lehman decade – the recommendation was for strong policy responses near the lower bound for interest rates (only). In other words, the update re-establishes a symmetric reaction function.

Hawkish, but not that new. Compared to the previous strategy, changes to the reaction function are by and large “hawkish”, but they have already been put into place in recent years to combat inflation: the strategy review simply solidifies these into higher-level principles.

There were also few surprises for markets since the changes have been well telegraphed, not least by Christine Lagarde herself in a speech in March.

I have four critiques and one question.

1. Thou shalt fear zero: low inflation and high inflation aren’t equal problems

“In the event of significant disinflationary shocks, the effective lower bound on nominal interest rates needs to be taken into account. In the event of significant inflationary shocks, possible non-linearities in price and wage setting need to be taken into account.”

Equating downside non-linearities in inflation with upside non-linearities is comparing apples with oranges.

Downside non-linearities in inflation are intimately connected with what Christine Lagarde herself calls “asymmetry of the policy space”.

That is, the lower bound (zero or other) is an exogenous, “hard constraint” on the central bank’s main instrument, the policy interest rate. And it’s this lack of policy space that can make low inflation self-perpetuating (and which had central banks look for other tools).

Such a constraint does not exist on the upside: the central bank can raise interest rates to whichever level is needed to defeat inflation – provided it’s willing to live with the consequences (the damage to the economy).

Why does this matter?

I could be wrong of course but treating those two things analytically as the same thing may be indicative of a certain degree of underestimation of the lower bound problem.

In turn, this is relevant for the tools the central bank uses.

2. Higher bar for QE, but what’s the alternative?

I detect signs in the ECB’s strategy document of a higher bar to do QE.

While this is not explicit, it becomes clear when one joins the dots:

• The governing council commits itself to do a “proportionality analysis” for the tools it employs. (This requirement – raised by the German constitutional court a few years ago in the context of QE – has already found its way into ECB communication.)

• There is also mention of “side effects” of policy tools in the context of macro-financial linkages and financial stability.

• These are words often used in explicit critiques of QE – including by ECB board members.

Now, my issue is not per se that QE should be used more sparingly.

Rather, I’m worried about the combination of an underestimation of the lower bound problem and a higher bar to do QE.

Because that would amount to potential policy inaction or delay near the lower bound – the exact opposite of what the updated strategy professes to do. (In my view, back in the 2010s, the ECB did QE too late, and partly because of that, did too much for too long.)

Alternatively, the strategy should have proposed which tool would be deployed preferentially at the lower bound if the bar for QE is higher.

Indeed, this is what Isabel Schnabel – one of the most prominent internal critics of QE – does: she proposes liquidity provision for banks at favourable rates instead (“targeted longer-term refinancing operations”).

However, there is no hierarchy of tools in the ECB’s updated strategy except for the (self-explanatory) primacy of the interest rate.

3. Higher or for longer? Rates won’t be a la carte every time

Or: the substitutability of “forcefulness” and “persistence”.

In English: we can choose between how high we raise rates (“forcefulness”) and how long we keep rates there (“persistence”).

In the ECB President’s words: “[P]ersistence ... can help limit the economic and financial stability costs compared with continued rate increases. ... persistence ... allowed the disinflation process to advance at a steady pace, while the so-called “sacrifice ratio” remained historically low compared with previous disinflation episodes.”

I’m worried that this is too sanguine a view of what happened, and one that assumes too much knowledge – and power – on behalf of central banks.

In my opinion, the fact that we have managed to avoid recession so far (in the euro area and elsewhere) has more to do with the particular economic circumstances we found ourselves in: the nature of shocks (a large part being supply, allowing swift and painless disinflation) and the fact that neutral rates turned out to be much higher than initially thought.

And yes, central bank conduct, also played a role.

They can be credited with avoiding a recession – they didn’t go too far in hiking interest rates. But surely they also got lucky.

They may not be next time around.

In any case, assuming there’s an a la carte choice between how high rates can be raised and for how long seems to me very optimistic.

4. Reaction function: everything, everywhere, all at once

The resulting – and key – policy prescription is for the ECB to take “forceful or persistent action to large sustained deviations in either direction”.

I don’t know about you, but to me this is just too vague to mean much. Essentially, it says that “we can do anything when things get dicey”.

Well, of course you can.

Q: How can you be more forceful, if inflation ends up being more volatile, as you expect?

More volatile inflation means more noise and less signal – you’re not sure, say, if an increase in inflation is permanent or transitory (sound familiar?). How do you then decide whether you ought to whack inflation on the head with a big hike or just leave it be, because it will disappear by itself?