From a macroeconomic point of view, the European Central Bank’s 0.25 percentage point interest rate cut on 6 June was not necessary – in view of tight labour markets, pockets of excess demand and continued supply bottlenecks. The ECB expects a further economic recovery. Unemployment in the euro area, 6.4% in April, is the lowest in decades. Fiscal policy is far from restrictive.
Taken in isolation, the rate cut is too small to worry about. But problems could arise if the view gains ground that further easing is on the way. Although Christine Lagarde and Joachim Nagel, the ECB and Deutsche Bundesbank presidents, have warned against expectations of speedy further cuts, splits can be expected on the governing council about next steps. Lagarde deserves praise for having forged cohesion in complex circumstances, but plotting the course from now on will be fraught with difficulties.
Lagarde had repeatedly stated that monetary policy decisions will be taken ‘on a data-dependent basis’ – ‘month by month and step by step’. However, given latest inflation figures, these conditions appear to have been met only partially. Monetary policy seems again more reliant on expectations and flexible interpretations of past data than on the most recent hard numbers.
An underlying issue is that a positive real interest rate may be highly desirable in current and future circumstances. There is still a deeply rooted aspiration, built up over several decades, for the lowest possible interest rates. The ECB should not too readily accede to that desire.
The fundamental problems of the European economy (and some European countries in particular) have nothing to do with the current level of interest rates. They have entirely different causes, such as stagnation in the growth of the labour force and the slow growth of productivity. The real issue is how to maintain per capita gross domestic product growth at a sufficiently high level. This requires policy focused on technology and labour markets. Interest rate cuts have very little impact on that.
‘Restrictive territory’
Expectations were fuelled, well before the interest rate cut, by an interview with Philip Lane, ECB board member for economics, when he said that, within the present ‘restrictive territory’, there was room in 2024 for further interest rate cuts.
By indicating that the (nominal) neutral policy rate stands slightly above 2% (or higher if climate transition or progress in artificial intelligence requires high investments), Lane quantified the concept of ‘restrictive territory’. He introduced a kind of forward guidance which, in other statements, the ECB has foresworn. His statement made it practically impossible for the governing council to decide differently on 6 June. There was no turning back, even though on 31 May, inflation came in higher than expected.
ECB statements on 6 June contain no convincing explanation for rate decision. Robert Holzman, president of Oesterreichische Nationalbank, the council’s sole dissident, was right when he said after the meeting that, ‘data-based decisions should be data-based decisions’.
Pressure on prices and wages
According to updated ECB projections, price stability will now be achieved a year later (by 2026) than foreseen in March 2024. As headline and core inflation have risen again in the last month, it is too easy to say that these are just bumps on the road. Although price pressures have weakened, domestic inflation remains high, particularly in the services sector.
As far as wages are concerned, the ECB seems to assume that ‘catch-up’ effects – after the prolonged period of compressed real wages – have now ended. But wages are still rising at an elevated pace. The size and duration of second-order effects are difficult to estimate in the context of a tight labour market.
In addition, pressure on prices and wages are likely to remain relatively high in our slowly growing economies facing increasing demands such as environmental concerns, demographic shifts, deglobalisation, AI and international conflicts.
From a risk management perspective, the ECB needs to take its alleged data-dependency approach more seriously. Before taking action, the ECB would have been wise to seek greater certainty regarding the macroeconomic situation, including wage and price developments. On 6 June, Lagarde substantiated the interest rate decision by referring to the reliability of recent ECB inflation forecasts. She should be far more cautious. The ECB cannot be allowed to forget that in 2021 (as staff have admitted) it made the largest inflation forecasting error in its history.
It is widely perceived that interest rates are currently high. But this is primarily because we have experienced a very long period of low interest rates. Economies can also thrive during periods of high nominal and positive real interest rates. Low real interest rates can cause or exacerbate distortions in the economy, such as excessively high asset prices and keeping alive ‘zombie’ companies, which delay necessary structural adjustments. Low-for-long interest rates can depress productivity and average interest rates on new loans and mortgages are much higher than in recent years. However, from an allocative perspective, this may not be unreasonable.
I hope that the inflation outlook turns out well. But if events take a turn for the worse – for example, through disappointing wage developments – the ECB could suffer grave reputational damage. The 6 June interest rate cut was a turning point. I fear it could turn out in the wrong direction.
Nout Wellink was President of De Nederlandsche Bank (1997-2011) and a member of the ECB Governing Council (1998-2011).
Image credit: European Central Bank
