The ECB needs a rethink of its policy approach

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a former supervisory board member of the European Central Bank and a senior fellow at Bocconi University and the Leibniz Institute for Financial Research SAFE

Experience suggests that abundant and cheap money is not a harbinger of price or financial stability, much less of sustained economic growth. The European Central Bank should bear that in mind as it seems prepared to loosen monetary policy further this year.

After cutting its deposit facility rate by one percentage point last year from 4 to 3 per cent, the ECB signalled that more cuts are coming. Markets now anticipate another percentage point cut this year to 2 per cent, or more according to some observers, on the grounds that inflation will soon reach the ECB’s 2 per cent target. But price stability, while in sight, is not secured yet. It is too early to conclude that the recent inflation outburst — the biggest so far in the short history of the euro — has ended.

Some inflation numbers have been encouraging in recent months, but not all. The year-on-year rate of increase of the euro area consumer price index rose steadily in the final quarter of 2024, from 1.7 per cent in September to 2.4 per cent in December. This is partly a statistical artefact: 12-month figures have been bloated by dips in prices a year earlier.

But service prices, which account for 45 per cent of the index as its largest component, shot up again in December. Energy prices were also a little higher, partly due to the euro’s depreciation against the dollar. President Donald Trump’s early statements after his return to the White House were short of specifics regarding tariffs on European exports, but if their enactment triggers further dollar appreciation, part of their inflationary impact may be exported.

If euro area inflation indeed approaches its target, as hoped, some changes in the ECB’s approach will be needed. Like a car driver nearing the end of a curve who looks further ahead and returns the steering wheel to the centre, the ECB must adopt a more forward-looking and balanced approach. It should clarify, to itself and others, what interest rate level it regards as the “new normal”. The review of its monetary policy strategy planned for 2025 offers an opportunity to rethink.

The backward-looking mode of the last two years, in which every move was “data dependent” and hence retrospective, needs to change. This means resurrecting inflation forecasting models that the ECB shelved back in 2022 after realising that they had misled policy for about a year.

Unfortunately, those models don’t seem to work well, and it is little consolation that the ECB’s are no worse than everyone else’s or even somewhat better. At critical junctures, they have wrongly predicted a rapid return to price stability — more wishful thinking than a genuine forecast. Inflation was found to be systematically more persistent than models predicted. Taking this into account may require a stronger policy reaction to deviations from the 2 per cent objective than econometric models suggest.

The monetary equivalent of returning a steering wheel to the centre involves shifting from a predominant focus on high inflation to consider a more even balance of risks above and below the 2 per cent target.

This requires an assessment of where the policy rate must be in equilibrium, when neither inflation nor recession risks are present. Estimates of the “natural rate” of interest are inconclusive: most of them suggest that such a rate declined after the 2008-09 crisis and rose again more recently, but the extent of the moves are unclear. Absent econometric precision, one may note that in the pre-crisis years short-term interest rates were on average around 1 per cent above the rate of inflation. This seems still today a plausible order of magnitude for a “neutral” rate, striking a balance between avoiding a tight monetary stance and ensuring a small positive real return on liquid savings.

Whichever side of the argument you look at, the conclusion is that with its benchmark rate at 3 per cent, the ECB has already used its available room to cut, even assuming price stability is about to be re-established. Of course, policy must be promptly loosened if signs of recession and deflation emerge; but we are not there now. Some euro area economic indicators that have come out after the turn of the year have actually improved. Punitive tariffs by the new US administration represent a risk for euro area growth but if, when and how they will materialise remains unclear. It is too early to act upon them.