The European Central Bank was unable to respond to soaring inflation by raising rates as early as many policymakers wanted due to a commitment to follow guidance it has now abandoned after nine years, according to those involved in the decision.
The ECB surprised many economists by raising interest rates for the first time since more than half a percentage point on Thursday, despite indicating until recently that it expected a move of just half. of this size.
Two of the bank’s board members told the Financial Times they believe it would have raised rates at least a month earlier if they hadn’t been bound by forecasts that wouldn’t rise until they bought more bonds in early July.
“A reasonable number of people on the board wanted to make 25 basis points in June,” an ECB rates official said. “Locking ourselves into a forward orientation hasn’t helped in this regard.” A second board member said the benefit of a June increase was outweighed by “the loss of credibility” that would have resulted from breaking its guidelines on when asset purchases would end, adding: ” It tied our hands.”
The news highlights how central banks are struggling to provide reliable guidance on their monetary policy plans after being caught up in the rapid rise in inflation to 40-year highs. Additionally, the ECB is grappling with a European energy crisis and political instability in Italy.
“Foresight has definitely overstayed its welcome,” said Spyros Andreopoulos, senior Europe economist at French bank BNP Paribas. “They continued to be surprised by the data, which affected their credibility.”
An ECB spokesman said the June board meeting in Amsterdam gave “unanimous” support for keeping rates unchanged and said he intended to hike by 25 basis points in July, with a larger movement probably in September.
ECB President Christine Lagarde said on Thursday that she had abandoned her previous forecast of the scale of future rate hikes after “preloading” her exit from negative rates and was now moving to a “meeting” approach. per meeting” to set borrowing costs. .
“We are much more flexible; in that we don’t offer any kind of forward guidance,” she said. “From now on, we will make our monetary policy decisions based on the data, [we] will work month by month and step by step.
The decision to abandon forward guidance on rates, which has been an important part of the policy toolkit since its introduction by former ECB chief Mario Draghi in 2013, has been widely welcomed by analysts – although some were still irritated by the way the central bank broke its last declared commitments.
“No advice is better than bad advice,” said Marco Valli, chief economist for Europe at Italian bank UniCredit. “This will likely increase the volatility of rate hike expectations as markets try to understand the ECB’s reaction function at a time of high, supply-driven inflation and a substantial weakening in economic activity. “
The ECB is the latest central bank to question the value of providing guidance. Last month, the US Federal Reserve scrapped its heavily advertised plans for a half-point rate hike just days before announcing its first 0.75 percentage point hike since 1994 after inflation increased more than expected.
Fed Chairman Jay Powell said after the decision that it was “highly unusual” for key data to land “very close” to a rate-setting meeting, adding: “I would like to think, however, that our predictions are still credible.”
The Bank of England surprised investors last year by not raising rates when a move was widely expected in November, then raising them when it was unexpected in December.
BoE chief economist Huw Pill said earlier this month that it would be “useless” to provide further guidance on rates as opinion was split among its policymakers. But days later, BoE Governor Andrew Bailey said his first half-point rate hike since 1995 “will be among the choices on the table at our next meeting” in early August.
ECB officials said the forward guidance was most helpful in signaling that rates would stay lower for longer once they cut them below zero and buy large amounts of bonds. “We are moving away from this world now,” an official said.
However, Lagarde provided some guidance on the future direction of rates on Thursday, signaling more hikes to come. “At our next meetings, further normalization of interest rates will be appropriate,” she said, adding that the central bank aimed to “raise interest rates gradually to [a] overall neutral setting. This is where we want to arrive.
Lagarde declined to estimate the neutral interest rate — the optimal level where an economy is neither overheated nor stunted — but other board members put it between 1 and 2%, meaning his deposit rate still has a long way to go from zero now.
The ECB chief also dropped the word “gradual” in describing his rate hike plans. She only used the word once at Thursday’s press conference – to describe wage growth – compared to seven times in June.
Board members criticized the concept of gradualism in June, when some said it “could be misleading if interpreted to imply too slow or too rigid a pace of adjustment in the stance of monetary policy.” , according to the minutes of last month’s meeting.
Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, suggested that the ECB publish its board members’ interest rate expectations over the next two years. This is similar to how the Fed releases its officials’ median rate expectations each quarter.
“The ECB needs to find a new way to signal its intention to the market,” Ducrozet said. “Otherwise it will add a layer of difficulty in predicting what they will do in future meetings.”
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