European Central Bank officials have begun discussing whether interest rates should be cut enough to stimulate the economy, ending years of economic restrictions, conversations with sources this week indicated.
The ECB has cut rates quickly this year, but officials have so far said the goal is a neutral scenario in which the central bank neither slows nor stimulates growth in the hope that this will keep inflation stable.
Although the sources, who spoke on condition of anonymity, stressed that a consensus is still far from being reached, this marks a significant shift in the monetary policy debate that could ultimately lead banks to cut rates early and more than currently expected.
The move comes at a time when the bloc’s economic situation is deteriorating rapidly and inflation is well below forecasts, raising the risk that price growth could fall below the ECB’s target, as was occurred almost a decade before the pandemic.
This is leading some politicians – a still small but growing group – to argue that the ECB is behind the curve and that deeper cuts than previously thought will be needed to prevent inflation from falling too low.
They also demand that the ECB revise its guidance of a “meeting by meeting” approach and abandon reference to restrictive rates as a sign that it is taking downside risks seriously.
“I don’t think neutrality is enough,” said a source with direct knowledge of the discussion. “This decision is still a long way off, but the economy has been stagnant for two years and there is no recovery in sight.”
Gediminas Simkus, head of the Lithuanian central bank and member of the governing council, was one of the first to discuss this risk publicly.
“If disinflation processes take hold… it’s possible that rates could be below the natural level. We’ve had this for decades,” he said this week. “Neutral” is sometimes called “natural.”
An ECB spokesperson declined to comment.
UNCERTAINTY
One uncertainty in the debate is that the neutral rate is considered unobservable and therefore there is no consensus on what it is.
“If you asked me today: ‘Where is he?’, the honest answer would be: ‘I don’t know,’” ECB President Christine Lagarde said this week.
But there are many estimates. The International Monetary Fund estimates it at 2.5%, ECB watchers polled by the bank see it around 2.25%, ECB staff believe it is closer to 2% or slightly higher, and the market suggests that now is less than 2%. Individually, officials see even wider gaps.
One difficulty is that the difference between the high and low of these ranges could be as much as three rate cuts.
The main argument in favor of cutting ECB interest rates below the neutral level is that economic growth is slow and the long-awaited recovery is simply not coming. This means that the ECB is constraining the economy much more than it expected and that high rates are depressing demand.
Without this growth pickup, domestic inflation will also slow and the labor market could weaken rapidly, increasing downward pressure on prices.
Source: Terra
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