The monetary debate seems hijacked by a simple set of questions: when will central banks reduce interest rates? How fast and by how much? While the US Federal Reserve System seems inclined to wait, recent statements from the European Central Bank suggest a rate cut will be decided at the ECB council’s next monetary policy decision-making meeting on 6 June. Is there space for it? Little, at best.
Pressure is significant. Financial institutions may profit from declining interest rates and looser credit conditions. Their desires are often aligned with those of indebted European governments keen to lock in cheaper borrowing costs.
The ECB’s anti-inflation stance appears to be working. Inflation has been declining towards the goal of 2%, but is not yet conquered. If there is one lesson we have learned from the recent past: Don’t take the future for granted.
Discounting the recent negative surprise – the May outturn surpassed expectations, for both headline and core inflation – a minor move of a quarter percentage point may fit in, but not the sequence of cuts that many market practitioners have recently been expecting. After that cut, the next stance must be ‘wait and see’.
It would also be the first time in its quarter-century-long life that the ECB cuts the policy rates when inflation is both above target and rising in its last reading, according to both metrics. Anything wrong with that? No, provided communication explains that the cut is ‘expectations based’, not ‘data dependent’. And, of course, that expectations turn out to be right.
Beyond the immediate issue of interest rate cuts, many other pressing matters need to engage central bankers’ attention. They have had to navigate frequent upheavals in the past two decades: near-collapse of financial systems followed by recession, massive prolonged monetary expansion, a global pandemic, another recession,  the worst inflation shock in the preceding half-century and now, war in Europe and in the Middle East.
What is monetary policy for in a radically changing world?
This combination of crises, and the often disjointed fiscal and monetary policy responses, raise many fundamental questions. These focus on the impact on both price and financial stability of prolonged monetary expansion and sharp changes in direction of monetary policy. Only a few have been tackled in a serious way, let alone answered properly.
Learning from the past two decades, how should we articulate and quantify central bank targets? How can the policy-making community better identify different sources of shocks and react to them? What are the merits and risks of negative rates? Should ‘exit strategies’ become part and parcel of any unconventional or extreme monetary policy move? What is the right degree of interest rate gradualism and pre-commitment? Most fundamentally, what interest rate should central banks aim for on average over the cycle?
Fed and ECB on different paths since 2015
The recent experiences of the US and the euro area highlight noticeable differences. Inflation performance was strikingly similar in the years preceding the Covid-19 pandemic, yet monetary policies diverged sharply.
The Fed raised its target (federal funds) interest rate decisively between 2015 and 2019, while the ECB brought its rate into negative territory and kept it there. When the pandemic hit, the Fed had more room for manoeuvre on interest rates. The ECB’s response relied mainly on quantitative easing through a new facility, the pandemic emergency purchase programme.
Both the Fed and the ECB delayed their response to the rise in inflation by about a year – the former between March 2021 and March 2022, the latter between August 2021 and July 2022.
Inflation started rising earlier in the US; in the euro area, it peaked later, at a higher level. In both cases, the delayed responses led to sudden and steep rate increases, but at quite different levels: the Fed from zero to 5.25%, the ECB from minus 0.5% to 4%. After all this action, the respective inflation rates, measured by the respective ‘headline’ indices are now roughly the same.
Need to rethink operational concepts and practices
The radically different and unpredictable global environment might have induced central bankers and other policy-makers to rethink operational concepts and practices. But this is at risk of not happening. The Fed and the ECB conducted monetary policy reviews in 2019-21, when most of the above shocks were still in the making or yet to come. Both of them seem largely obsolete today, or at least incomplete.
Judging by the review by Ben Bernanke for the Bank of England, largely limited to forecasting techniques and communication, there is little appetite for a wider angled view on these questions. Academic research takes time and tends to lag well behind events.
Simple-minded monetarist theories are largely discredited today, but it is impossible to look at the last 15 years without asking whether the prolonged phase of QE and the absence of proper exit strategies, caused or at least contributed to the rise of global inflation in the early 2020s.
The question extends to financial stability. In the US, the unprecedented sequence of hasty expansion and restriction in 2020-22, with ensuing massive shifts in bank balance sheets, was one of the main reasons for the spring 2023 banking turmoil.
Monetary policy and financial stability, traditionally separate within central banks with limited interaction and cross-checks between them, may be more related than we thought.
All these questions are fundamental to understanding and steering the global economy. Policy-makers need to show greater willingness to devise ways of coming up with some answers.
With the broader questions still unanswered, the economic ‘permacrisis’ – the expression used by Gordon Brown, Mohammed El Erian and Michael Spence in a recent book – is at risk of being wasted. In this policy-making vacuum, the right approach should be dictated by prudence. ‘If you don’t know what you are doing, do it gently’, as an old motto goes.
Ignazio Angeloni is part-time Professor at the Robert Schuman Center, European University Institute, Non-resident Fellow of Institute for European Policymaking at Bocconi University, Senior Policy Fellow, SAFE, Goethe University Frankfurt and a former member of the European Central Bank Supervisory Board.
