As an aside, central banks’ forward guidance on rates and/or asset purchases may well have outlived its usefulness in a changing macro environment. As we argued in our 2021 Secular Outlook Age of Transformation, business cycles in the years ahead are likely to be shorter in duration and larger in amplitude, with both economic growth and inflation becoming more volatile. Such an environment would likely require more frequent and more pronounced monetary policy changes and even turnarounds in reaction to rapidly changing cyclical conditions. In such an environment, tying one’s hands through forward guidance, even though only conditionally, could become a hindrance rather than a help for effective monetary policies.
Back to the ECB, while the arguments above for a change in the monetary policy stance – risk management and the politics of negative interest rates– should not be dismissed easily, I believe that the risks of a premature tightening would outweigh the benefits, for three reasons.
First, I have yet to be convinced that tightening into a huge supply shock caused by Covid-19 and surging oil prices is a sensible policy. Demand in the euro area is far less buoyant than in the United States as fiscal policy has been less expansionary and pandemic-related restrictions have been more stringent. Also, nominal wage growth has remained very subdued so far, which together with high current inflation implies a significant reduction in households’ real disposable income. Tightening monetary policy would add insult to injury.
Second, tightening monetary policy would contradict the ECB’s declared goal of re-anchoring long-term inflation expectations around the 2% symmetrical inflation target. In fact, five-year-five year forward breakeven inflation rates, which despite the increase over the past year had still be been undershooting the target, nosedived in response to the hawkish pivot at last Thursday’s council meeting.
Third, exiting net asset purchases and raising policy rates increases the risk of financial accidents, especially as debt levels have surged during the pandemic and as many other central banks are tightening policy at the same time. Given its peculiar ‘one money, many nations’ institutional set-up, the euro area remains subject to the risk of financial fragmentation between its many sovereign bond markets and national banking systems. While some of this could be mitigated with the help of a flexible reinvestment strategy (which continues to be possible under the PEPP umbrella) and through targeted lending operations for banks, the risk of self-fulfilling runs on sovereigns and banks remains real, especially if the ECB shifts to fighting an actual or perceived inflation problem.
Given these risks, and mindful of the 2008 and 2011 episodes of ill-timed ECB tightening, cool heads and steady hands are still likely to prevail at the ECB. However, the risk of yet another policy mistake have clearly increased – a view that many market participants seem to share given the inversion of the 10s-30s yield curve and the plunge in longer-dated forward breakeven inflation rates. Yet another reason to prepare for a more uncertain, uneven and volatile macro environment in 2022 and beyond!
